Ciscm Studyguide

CISCP-CISCM STUDY GUIDE
©International Purchasing and Supply Chain Management Institute, 2012 1

TABLE OF CONTENTS
PART PAGE
PART I
Materials, Production, Inventory, Logistics, and Supply Chain Management 3
PART II
MRP, MRPII, ERP, JIT, SRM/CRM 186
PART III
Green Logistics 209
PART IV
Purchasing 218
PART V
Practice CISCM Examination 312
PART VI
Body of Knowledge and Reference List 316

PART I. SUPPLY CHAIN MANAGEMENT
Supply-Production-Distribution System
There are three phases to the flow of materials:
Raw materials flow into a manufacturing company from a physical supply system.
Raw materials are processed by manufacturing.
Finished goods are distributed to the end consumer through a physical distribution system.
What happens in any one of the above phases will affect the others.
Conflicts in Traditional Systems
In the past, supply, production, and distribution systems were organized into separate functions
that reported to different departments of a company.
Often policies and practices of the different departments maximized objectives of the departments
without much thought being given to the effect they would have on other parts of the system
Because the three systems were interrelated, usually there were conflicts.
While each system made decisions that were best for itself, overall company objectives suffered
Distribution would tend to ship in the largest quantities possible so it could minimize shipping
costs. However this increased inventory and resulted in higher inventory-carrying costs
Other ―Sub optimizing‖ can take place in the overall system.
There are four main ways to maximize profit:
1. Provide best customer service.
2. Provide lowest production costs.
3. Provide lowest inventory investment.
4. Provide lowest distribution costs.
Objectives and Departments are often in conflict.
Marketing, production, and finance have conflicting objectives.
Marketing's objective is to maintain and increase revenue. To do so it must provide the best
customer service possible. It can:

 Have high inventories so goods are always available for the customer.
 Interrupt production runs so a noninventoried item can be supplied quickly.
 Have an extensive and costly distribution system so goods can be shipped to the customer
quickly.
Finance will want to keep investment and costs low. This can be done by:
 Reducing inventory so inventory investment is at a minimum.
 Reducing the number of plants and warehouses
 Producing in large quantities using long production runs
 Producing only to customer order.
Production will want to keep its production costs as low as possible. This can be done by:
 Making long production runs of relatively few products. This means there would be few
changeovers to make to the processes and specialized equipment can be used, thus reducing
the cost of making the product.
 Maintaining high inventories of raw materials so production is not disrupted by shortages.
These conflicts between marketing Finance and Production center on customer service disruption
of production flow and inventory levels.
Today the concepts of Just-In-Time (JIT) manufacturing stress the need to supply customers with
what they want and when they want it and to keep inventories at a minimum. These objectives put
further stress on the relationship between production, marketing, and finance.
Conflict Resolution Strategy
One important way to resolve these conflicting objectives is to provide close coordination of the
supply, production, and distribution functions.
To do so requires a type of integrated materials or logistics organization responsible for supply,

production, and distribution.
Rather than having the planning and control ofF these functions spread between marketing,
production, and distribution, they should occur in a single area of responsibility

What is Materials Management?
The concept of having one department responsible for the flow of materials, from supplier
through production, is relatively new.
While many companies have adopted this type of organization, there are still a number that have
not.
If companies wish to minimize total costs in this area and provide a better level of customer
service, they will move in this direction..
The name usually given to this function is materials management.
The management of materials from production to the customer is normally called distribution
management, while the entire materials and distribution process is called logistics
management (old name) or supply chain management (new name).
Materials management is a coordinating function responsible for the planning and controlling of
materials flow. Its objectives are to maximize the use of the firm's resources and provide the
required level of customer service.
Profit Maximization
Reducing material flow costs contributes directly to profit.
Materials management and distribution management (which together make up supply chain
management), can reduce costs by being sure that the right materials are in the right place at
the right time and the resources of the company are properly used.
Components of Supply Chain Management
Manufacturing Planning and Control
This function is responsible for the planning and control of the flow of materials through the
manufacturing process. Primary activities include:
 Production planning, including forecasting and master planning.

 Material requirements planning.
 Capacity planning.
 Implementation Control
Responsible for putting into action and achieving the plans made by production planning.
Accomplished by:

 Production activity control (often called shop floor control).
 Purchasing.
Inventory Management
Inventories are materials and supplies carried on hand either for sale or to provide material or
supplies to the production process.
Inventories are part of the planning process and provide a buffer against the differences in
demand rates and production rates.
A convenient measure of how effectively inventories are being used is inventory turns. Inventory
turns: defined as annual cost of goods sold divided by average inventory in dollars. The
calculation of average inventory can be complicated and is more a subject for cost accounting.
Inputs to the Manufacturing Planning and Control System
 Product Description: Tells how the product will appear at some stage of production.
 Engineering drawings and specifications.
 Bill of material (describes the components used to make the product, and the subassemblies
at various stages of manufacture.
 Product Specification: Describes the steps necessary to make the end product. A step-by-
step set of instructions describing how the product is made. Usually recorded on a route
sheet or in a routing file. Gives information such as Operations required to make the
product; Sequence of operations; Equipment and accessories required; and Standard time to
perform each operation (time taken by an average operator working at a normal pace to
perform a task)
Physical Supply and Distribution
Includes all the activities involved in the movement of goods from the supplier to the beginning
of the production process and from the end of the production process to the consumer.
Activities include:
 Transportation
 Distribution inventory
 Warehousing
 Packaging
 Materials handling
 Order entry

Supply Chain Management Concerns
The overall concern is the balance between priority and capacity.
The marketplace sets demand. Supply Chain Management must plan the firm's priorities (what
goods to make and when) to meet that demand.
Capacity is the ability of the system to produce or deliver goods.
Priority and capacity must be planned and controlled so customer demand can be met at
minimum cost.
Manufacturing Systems (Three Types)
1. Line flow manufacturing
2. Intermittent (batch) manufacturing
3. Project manufacturing
The system used depends on demand for the item, output rate, range of products, and ease or
difficulty of moving material
All three systems can be used to make discrete items such as automobiles or textbooks or
nondiscrete products such as gasoline, paint, or fertilizer.
Line Flow Manufacturing
All the work stations required to make a product or family of similar products, are grouped
together into one department.
Each work station is located in the sequence needed to make the product.
Examples are assembly lines, cafeterias, oil refineries, and steel-rolling mills. Work flows from
one work station to the next at a relatively constant rate and with no delays.
In addition, there will be some mechanical methods of moving goods between work stations.
Line flow systems only produce a limited range of similar products.
An assembly line produces a certain type of car or refrigerator. If designed to make refrigerators,
it cannot be used to assemble washing machines. The operations used to make one are different
and in a different sequence than those used for the other
Because line flow systems are limited in the variety of products they make, there has to be a large
enough demand for the products to economically justify setting up the line.

If sufficient demand exists, line flow systems are extremely efficient for the following reasons:
 They are designed specifically for the tasks required.

 They are usually designed to minimize the labor needed.
 Because work flows from one work station to the next, there is little buildup of inventory
between work stations.
Work flows down a line and parts must flow to the work stations on the line at a rate equal to
their use.
Where the line makes some variety, such as in the automotive industry, the various parts must
flow together so a four-door car in fact gets four doors.
The Flow and the coordination of variety must be planned.
The manufacturing planning and control system is called flow control.
Intermittent Manufacturing
Goods are not made continuously as in a line flow system but are made at intervals in lots or
batches.
Work stations must be capable of processing many different parts.
It is necessary to use general-purpose work stations and machinery that can perform a variety of
tasks.
General-purpose work stations do not produce goods as quickly as special-purpose work stations
used in line flow manufacturing.
Usually work stations are organized into departments based on similar types of skills or
equipment.
All welding and fabrication operations are located in one department, machine tools in another,
and assembly in yet another department.
Work moves only to those work stations needed to make the product and skips the rest.
Intermittent operations are flexible.
Intermittent operations can change from one part or task to another quicker than flow operations.
This is because they use general-purpose machinery and highly skilled labor. Skilled labor must
be used so they can perform the variety of operations needed.
Control of the flow of work is managed through individual work orders for each lot or batch
being made.

Because of this and the jumbled pattern of work flow, manufacturing planning and control
problems are severe.
Often there are many work orders in existence, each of which can be processed in different ways.

Comparison: Intermittent and Line Flow Manufacturing
Line flow manufacturing is less costly than intermittent manufacturing. Reasons include:
 Set up costs are low. Once the line is established, it will be changed over to run another
product very infrequently.
 Since work centers are designed for specific products, run costs will be low.
 Because products move continuously from one work station to the next, work-in-process
inventory will Be low
 Costs associated with controlling production arc low because work flows through the process
in a fixed sequence
Project Manufacturing
Sometime called Fixed Position Manufacturing.
Usually used for large complex projects such as locomotives, ships, or buildings.
The product may remain in one location For its full assembly period, as with a ship, or it may
move from location to location after considerable work and time is spent on it.
Large aircraft are made this way
Has little advantage except it avoids the very high costs of moving the product from one work
station to another.
Combination of Types
Manufacturing companies try to find the best combination to make their products.
In any one company it is not unusual to see examples of all three being used.
Each of the manufacturing systems requires planning for the flow of materials so the right
material arrives at the right time and in the right quantities.
Techniques For planning and controlling the flow vary somewhat in each. But the basic need is
the same.
Summary
Manufacturing creates wealth by adding value to goods.
To improve productivity and wealth, a company must first design efficient and effective systems
for manufacturing.
It must then manage these systems to make the best uses of our resources of labor, capital, and
material.

One of the most effective ways of doing this is through the planning and control of the flow of
materials into, through, and out of manufacturing.
A planning and control system must answer four questions:
1. What are we going to make?
2. What does it take to make it?
3. What do we have?
4. What do we have to get?
Questions of priority and capacity
Priority relates to what products are needed, how many are needed and when are they needed.
The marketplace establishes the priorities. It is manufacturing's responsibility to devise plans to
satisfy the market demand if at all possible.
Capacity is the capability of manufacturing to produce goods and services. It depends on the
resources of the company (the machinery, labor, and financial resources), and the availability of
material from suppliers.
For our purposes capacity is the quantity of work that labor and equipment can perform in a given
period of time.
In the long and short run manufacturing must devise plans to balance the demands of the
marketplace with its resources and capacity.
For long-range decisions such as the building of new plants or the purchase of new equipment.
The plans will have to be made for several years. For planning production over the next few
weeks the time span will be days or weeks
There are five levels in the manufacturing planning and control (MPC) system:
1. Business planning
2. Production planning
3. Master production scheduling
4. Material requirements planning
5. Production activity control
Changes in Levels
In general, as we move from business planning to production activity control, the purpose will
change from overall direction to detailed planning; the time span will decrease from years to a

day; and the level of detail will increase from general categories to individual components and
work stations.
Levels Differ With Respect To:
 Purpose of the plan
 Planning horizon
 Level of detail
 Planning cycle
Three Appropriate Questions at Each Level
1. What are the priorities (how much of what is to be produced and when)?
2. What is the available capacity?
3. How can differences between priorities and capacity be resolved?
The Business Plan
It is a statement of the major goals and objectives the company hopes to achieve over the next 2-
5 years or more.
It is also a statement of the broad direction of the firm and shows the kind of business—product
lines, markets, and so on the firm wants to do in the future. The business plan gives general
direction as to how the company hopes to achieve these objectives.
It is based on long-range forecasts and includes inputs fom marketing, finance, and production. In
turn, the plan provides direction and coordination between the marketing, production, and
financial plans.
Business Plan Development
Responsibility of senior management.
Using inputs from marketing, finance, and production, the business plan provides a framework
that sets the goals and objectives for further planning by the marketing, finance, and production
departments.
Each department produces its own plans to achieve the objectives set by the business plan.
Usually business plans are reviewed every 6 months to a year.
Production Plan

The quantities of each product group to produce in each time period.
The desired inventory levels.
The resources of equipment, labor. and material needed in each time period.
The availability of the resources needed.
The Master Production Schedule
A plan for the production of individual end items.
It breaks down the production plan to show, for each time period, the quantity of each end item to
be made.
Level of detail if higher than for the production plan.
Material Requirements Plan (MRP)
A plan for the production and purchase of the components used in making the items in the master
production schedule.
It shows the quantities needed and when manufacturing intends to make or use them.
The MRP will be used by purchasing and production activity control to decide the purchase or
manufacture of specific items.
The level of detail is high. The MRP establishes when the components and parts are needed to
make each end item
The planning horizon is at least as long as the combined purchase and manufacturing lead times.
As with the master production schedule, it usually extends from 3 to 18 months.
Purchasing and Production Activity Control
The implementation and control phase of the production planning and control system.
Purchasing is responsible for establishing and controlling the flow of raw materials into the
factory.
Production activity control is responsible for planning and controlling the flow of work through
the factory.
The planning horizon is very short, perhaps from a day to a month.

The level of detail is high since it is concerned with individual components, work stations, and
orders.
Plans will be reviewed and revised daily.
Capacity Management
The basic process is one of determining the capacity needed to manufacture the priority plan and
of finding methods for making that capacity available.
A valid, workable production plan cannot be made unless this is done.
If the capacity cannot be made available when it is needed, then the plans will have to be changed.
Determining the capacity required, comparing it to available capacity, and making adjustments
(or changing plans) must occur at all levels of the manufacturing planning and control system
Manufacturing Resource Planning (MRP II)
Because of the large amount of data and the number of calculations needed, the system will
usually have to be computer-based.
The time and labor required to do calculations manually is extensive and forces a company into
compromises.
Instead of scheduling requirements through the planning system, the company may be forced to
extend Lead times and build inventory in order to compensate for the inability to quickly schedule
what is needed and when.
The system is intended to be a fully integrated planning and control system that works from the
top down and has feedback from the bottom up.
Business planning integrates the plans and activities of marketing, finance, and production to
produce plans that are intended to achieve the overall goals of the company.
In turn, master production scheduling, material requirement planning, production activity control,
and purchasing are directed toward achieving the goals.
There must be feedback throughout the system. This is called closed-loop MRP.
The manufacturing planning and control system, as described here, forms a master game plan for
all departments in the company. This fully integrated planning and control system is the
manufacturing resource planning, or MRP II, system.
MRP II provides coordination between marketing and production.
Marketing, finance, and production agree on an overall workable plan that is expressed in the
production plan.

Marketing and production must work together on a weekly and daily basis to make adjustments to
the plan as changes occur.
Order sizes may need to be changed, orders canceled, and delivery dates adjusted.
Ordering changes are made through the master production schedule.
Marketing managers and production managers may change master production schedules to meet
changes in forecast demand.
Senior management may adjust the production plan to reflect overall changes in demand or
resources. But they all work through the MRP II system. It provides the mechanism for
coordinating the efforts of marketing, finance, production, and other departments in the company.
Enterprise Resource Planning (ERP)
ERP = Process of planning & managing all resources & their use in the entire enterprise.
Leading ERP software producers: SAP, Oracle, J.D. Edwards, Computer Associates, People Soft.
Main objective of ERP is to integrate all departments & functions across a company onto a single
computer system.
Enterprise resource planning (ERP) further integrates the transaction processing as well as other
routine activities in the entire enterprise.
*Integration continues along several paths:
 Functional areas
 Combining transaction processing and decision support
 Business intelligence
 CRM software
ERP or enterprise systems control all major business processes with a single software architecture
in real time. It is comprised of a set of applications that automate routine back-end operations
such as:
 Financial management
 Inventory management
 Scheduling
 Order fulfillment
 Cost control
 Accounts payable and receivable,
 Front-end operations such as POS, Field Sales, and Service
It also increases efficiency, improves quality, productivity, and profitability.

Making the Production Plan
Based on the market plan and available resources, the production plan sets the limits or levels of
manufacturing activity for some time in the future.
The production plan integrates the capabilities and capacity of the factory with the market and
financial plans to achieve the overall business goals of the company.
The production plan sets the overall levels of production and inventories over the planning
horizon.
Its prime purpose is to establish production rates that will achieve the objectives of the business
plan. These include inventory levels, backlogs (unfilled customer orders), market demand.
customer service, low-cost plant operation, labor relations, and so on.
The plan must extend out in time far enough to plan for the labor, equipment, facilities, and
material needed.
Typically, this is a period of 6-18 months.
The plan is done in weekly or monthly time periods
Establishing Product Groups
Firms who make a single product or products that are similar can measure their output directly by
the number of units they produce.
Many companies, however, make several products that are quite different, and a common
denominator for measuring total output may be difficult, or impossible, to find.
These firms need to establish product groups based on the similarity of manufacturing processes.
Manufacturing must provide the capacity to produce the goods needed.
It is therefore not so much concerned with the demand for product as the demand for the specific
kinds of capacity needed to make the products.
Importance of Capacity
Capacity is the ability to produce goods and services.
It can be expressed as the time available or, sometimes, as the number of units that can be
produced in a given period.
The demand for goods must be translated into the demand for capacity.

At the production planning level, where little detail is needed, this requires identifying product
groups, or families, of individual products based on the similarity of manufacturing process.
Over the time span of the production plan, large changes in capacity are usually not possible.
Additions or subtractions in plant and equipment are impossible or very difficult to accomplish in
this time period.
Variations Possible
Some things can be altered, and manufacturing management must identify and assess them.
People can be hired and laid off, overtime and short time can be worked, and shifts can be put on
and removed; inventory can be built up in slack periods and sold or used in periods of high
demand; and work can be subcontracted or extra equipment leased.
Manufacturing management must find the least cost alternative consistent with the goals and
objectives of the business.
Production Planning Characteristics
A time horizon of 12 months with periodic updating perhaps every month or quarter.
Production demand consists of one or a small number of product families or common units.
Demand is fluctuating or seasonal.
Plant and equipment are fixed within the time horizon.
A variety of management objectives such as low inventories, efficient plant operation, good
customer service, good labor relations, and so on.
Production Planning Strategies
 Demand matching
 Production leveling
 Subcontracting
Demand Matching
Demand matching is producing the amounts demanded at any given time.
The firm manufactures just enough at any one time to meet demand, no more no less. Examples
are farmers, the post office, and restaurants.

These industries cannot stockpile or inventory their product or service and must be capable of
meeting user demand as it occurs.
The company must have enough capacity to be able to meet the peak demand.
The advantage to demand matching is that inventories can be kept to a minimum.
Goods will be made when demand occurs and not stockpiled.
The costs associated with carrying inventories are avoided.
Production Leveling
Producing continually an amount equal to the average demand.
Companies determine their total demand over the time span of the plan and, on the average,
produce enough to meet it.
Sometimes demand is less than the amount produced and an inventory builds up.
At other times demand is greater and inventory is used up.

The advantage of a production leveling strategy is that it results in a smooth level of operation
that avoids the costs of changing production levels.
Firms do not need to have excess capacity to meet peak demand.
They do not need to hire and train workers and lay them off in slack periods. They can build a
stable work force.
The disadvantage is that inventory will build up in low demand periods. This inventory will cost
money to carry.
Subcontracting
Means always producing at the level of minimum demand and meeting any additional demand
through subcontracting.
The major advantage is cost--costs associated with excess capacity are avoided, and because
production is leveled, there are no costs associated with changing production levels.
The main disadvantage is that the cost of purchasing (item cost, purchasing, transportation, and
inspection costs) may be greater than if the item were made in the plant.
Few companies make everything or buy everything they need.
In addition to cost are a number of other needs which may operate in a given decision:

 To keep confidential processes within the company.
 To maintain quality levels and maintain a work force.
 To buy from a supplier who has special expertise in design and manufacture of a component.
 To allow the firm to concentrate in its own area of expertise.
 To provide known and competitive prices.
Hybrid Strategy
The three strategies discussed so far are pure strategies--each has its own set of costs: equipment
hiring/layoff; overtime; inventory; and subcontracting.
In reality there are an infinite number of possible hybrid or combined strategies--each will have
its own set of cost characteristics.
It is production management's job to find the combination of strategies that minimizes the sum of
all costs involved, provides the level of service required, and meets the objectives of the financial
and marketing plans.
Developing a Make-to-Stock Production Plan
In a make-to-stock environment products are made and put into inventory before an order is
received from a customer.
Sale and delivery of the goods are made from inventory.
Off-the-rack clothing, frozen foods, and bicycles are examples of this kind of manufacturing.
Situations Favoring Make-to-Stock.
 When demand is fairly constant and predictable.
 When there are few product options.
 When delivery times demanded by the marketplace are much shorter than the time needed to
make the product.
 When product has a long shelf life.
Information needed to make a production plan
 Forecast by time period for the planning horizon
 Opening inventory
 Desired ending inventory

 Any past due customer orders--orders that are late for delivery and are sometimes called back
orders
Production Plan Objectives
Minimize the costs of carrying inventory; changing production levels; and stocking out.
Level Production Plan Steps
1. Total Forecast demand for plan horizon.
2. Determine opening inventory and desired ending inventory.
3. Calculate total production required as follows: Total Production = total forecast + back orders
+ ending inventory - opening inventory.
4. Calculate production required each period by dividing total production by number of periods.
5. Calculate ending inventory for each period.
Developing a Make-to-Order Production Plan
In a make-to-order environment, manufacturers wait until an order is received from a customer

before starting to make the goods.
Firms generally make to order when:
Goods are produced to customer specification.

Customer is willing to wait while the order is being made.
Product is expensive to make and store.
Several product options are offered.
Assemble to Order
Where several product options exist, such as in automobiles; and where the customer is not
willing to wait until the product is made, manufacturers produce and stock standard component
parts.
When manufacturers receive an order from a customer, they assemble the component parts from
inventory according to the order.
Since the components are stocked, the firm only needs time to assemble before delivering to the
customer.
Examples of assemble to-order products include automobiles, computers, and appliances.
Assemble to order is a subset of make to order.

A production plan for assemble to order needs the following information:
 Forecast by time period for the planning horizon

 Opening backlog of customer orders
 Desired ending backlog
A firm does not build an inventory of finished goods.
Instead it has a backlog of unfilled customer orders.
This backlog normally will be for delivery in the future and does not represent orders that are late
or past due.
Level Production Plan Development
1. Total Forecast Demand.
2. Determine Opening backlog and desired ending backlog.
3. Calculate total production: Total production = total forecast + opening backlog – ending
backlog.
4. Calculate production required/period by dividing total production by number of periods.
5. Spread the existing backlog over the planning horizon according to due date per time period.
Resource Requirements Planning
Once the preliminary production plan is established it must be compared to the existing resources
of the company.
This step is called resource requirements planning.
There are two questions that have to be answered:
1. Are the resources available to meet the production plan?

2. If not, how will the difference be reconciled?
If enough capacity to meet the production plan cannot be made available then the plan must be
changed
A tool often used is the resource bill. This shows the quantity of critical resources (material; labor
and bottleneck operations) needed to make one average unit of the product group.
Summary

Production planning is the first step in a manufacturing planning and control system.
The planning horizon usually extends out for a year.
The minimum horizon depends on the lead times to purchase materials and make the product.
The level of detail is not high.
Usually the plan is made for families of products that are based on the similarity of manufacturing
process or on some common unit.
There are three basic strategies that can be used to develop a production plan: demand matching;
leveling production; and subcontracting.
Each strategy has its operational and cost advantages and disadvantages.
It is the responsibility of manufacturing management to select the best combination of these basic
plans so total costs are minimized and customer service levels are maintained.
A make-to-stock production plan determines how much to produce in each period so as to meet
the following objectives:
To achieve the forecast

To maintain the required inventory levels
While demand must be satisfied, the plan must balance the costs of maintaining inventory with
the cost of changing production levels.
Master Production Scheduling
After production planning, the next step in the manufacturing planning and control process is to
prepare a master production schedule (MPS).
The MPS is an extremely important planning tool and forms the basis for communication
between sales and manufacturing.
Importance of MPS
The MPS forms the link between production planning and what manufacturing will actually build.
It forms the basis for determining capacity and the resources that will be needed and the basis for
material requirements planning
The MPS and bills of material determine what components will be needed from manufacturing
and purchasing. The MPS drives the material requirements plan.
MPS keeps priorities valid. The MPS is a priority plan for manufacturing.

MPS Characteristics
While the production plan deals in families of products, the MPS works with end items.
It breaks down the production plan into the requirements for individual end items in each of the
families by date and quantity.
The production plan limits the MPS.
The total of the items in the MPS should not be different from the total shown on the production
plan.
Within this limit, its objective is to balance the demand (priorities) set by the marketplace with
the availability of materials, labor, and equipment (capacity) of manufacturing.
The end items made by the company are assembled from component and subcomponent parts.
These must be available in the right quantities at the right time to support the master production
schedule.
The material requirements planning system plans the schedule for these components based on the
needs of the MPS. The MPS thus drives the material requirements plan
The MPS reflects the needs of the marketplace and the capacity of manufacturing, and forms a
priority plan for manufacturing to follow.
The MPS forms a vital link between sales and production as follows:
It makes possible valid order promises

It plans what is to be produced and when. As such, it tells sales and manufacturing when goods
will be available for delivery.
It is a contract between marketing and manufacturing
The MPS forms a basis for sales and production to determine what is to be manufactured.
It is not meant to be rigid.
It is a device for communication and a basis to make changes that is consistent with the demands
of the marketplace and the capacity of manufacturing.
Information needed to develop an MPS
 The production plan
 Forecasts for individual end items
 Actual orders received from customers and for stock replenishment

 Inventory levels for individual end items
 Capacity restraints
Objectives in developing an MPS
1. To maintain the desired level of customer service.
2. To make the best use of material, labor, and equipment.
3. To maintain inventory investment at the required levels.
4. (To achieve these objectives, the plan must satisfy customer demand, be within the capacity
of manufacturing, and be within the guidelines of the production plan.)
Three steps in preparing an MPS
1. Develop a preliminary MPS.
2. Check the preliminary MPS against available capacity.
3. Resolve differences between the preliminary MPS and capacity availability.
Preliminary Master Production Schedule
The process of building an MPS occurs for each item in the family.
If the total planned production of all the items in the family and the total ending inventory does
not agree with the production plan, then some adjustment to the individual plans must be made so
the total production is the same.
Once the preliminary MPS are made, they must be checked against the available capacity--This
process is called rough-cut capacity planning.
Rough-Cut Capacity Planning
Checks whether critical resources are available to support the various preliminary MPS.
Critical resources include "bottleneck" operations, labor, and critical materials (perhaps material
that is in short supply or has a long lead time).
The process is similar to resource requirements planning used in the production planning process.
The difference is that now we are working with a product and not a family of products.
Resolution of Differences

The next step is to compare the total time required to the available capacity of the work center.
If available capacity is greater than the required capacity, then the MPS is workable.
If not, then ways of increasing capacity have to be investigated.
Is it possible to adjust the available capacity with overtime, extra workers, routing through other
work centers, or subcontracting? If not, then it will be necessary to revise the master production
schedule.
Three Criteria for Judging the MPS
1. Resource Use--Is the MPS within capacity restraints in each of the time periods of the plan?
Does it make the best use of resources?
2. Customer service--Will due dates be met and will delivery performance be acceptable?
3. Cost--Is the plan economic or will excess costs be incurred for overtime, subcontracting,
expediting, or transportation?
Which Items to Master Schedule?
The MPS should represent what manufacturing will make.
It should do so as efficiently as possible.
If too many items are included, it will lead to difficulties in forecasting and managing the MPS.
In each of the manufacturing environments, make to stock, make to order, and assemble to order,
master scheduling should take place where the smallest number of product options exists.
Make to Stock
A limited number of standard items are assembled from many components.
Televisions are an example.
The MPS is usually a schedule of finished-goods items.
Make to Order
Many different end items are made from a relatively small number of components.
Custom-tailored clothes is an example.
The MPS is usually a schedule of the actual customer orders.

Assemble to Order
Many end items can be made from combinations of basic components and subassemblies.
This last step, assembly to customer order, is usually planned using a final assembly schedule
(FAS).
The FAS is a schedule of what will actually be assembled. It is used when there are many options
and it is difficult to forecast the combination customers will want.
Master production scheduling is done at the component level.
The FAS schedules customer orders as they are received and is based on the components planned
in the MPS.
It is responsible for scheduling from the MPS through final assembly and until shipment to the
customer.
Planning Horizon
The planning horizon is the time span for which plans are made.
It must cover a period at least equal to the time required to accomplish the plan.
For master production scheduling the minimum planning horizon is the longest cumulative or
end-to-end lead time (LT).
The planning horizon is usually longer for a number of reasons.
The longer the horizon, the greater the "visibility" and the better management's ability to act to
avoid future problems or to take advantage of special circumstances.
Firms might be able to take advantage of economical purchase plans, to avoid future capacity
problems, or manufacture in more economical lot sizes.
As a minimum. the planning horizon for a FAS must include time to assemble a customer's order.
It does not need to include the time necessary to manufacture the components. That time will be
included in the planning horizon of the MPS.
Production Planning, Master Production Scheduling, and Sales
The production plan reconciles total forecast demand with available resources.
It takes information from the business plan and market forecasts to produce an overall plan of
what production intends to make to meet forecast.

It is dependent on the forecast and, within capacity limits, must plan to satisfy the forecast
demand.
It is not concerned with the detail of what will actually be made.
It is intended to provide an overall plan, or framework, in which detailed plans can be made in the
MPS.
The MPS is built from forecasts and actual demands for individual end items.
It reconciles these demands with the production plan and with available resources to produce a
plan that manufacturing can fulfill.
It is concerned with what items will actually be built, in what quantities, and when, in order to
meet expected demand.
The production plan and the MPS uncouple the sales forecast from manufacturing by establishing
a manufacturing plan.
They attempt to balance available resources of plant, equipment, labor, and material with forecast
demand.
The MPS is a plan for what production can and will do.
The MPS must be realistic in terms of what manufacturing can and will do.
If it is not, it will result in overloaded capacity plans, past due schedules, unreliable delivery
promises, surges in shipments, and lack of accountability.
The MPS is a plan for specific end items or "buildable" components that manufacturing expects
to make over some time in the future.
THE MPS is where manufacturing and marketing agree on end items to be produced.
Manufacturing is committed to make the goods and marketing to their sale.
The MPS is not meant to be rigid--Demand changes, problems in production, and sometimes
components in short supply may make it necessary to alter the MPS.
Changes must be made with agreement of sales and production. The MPS provides the basis for
making changes and a plan on which all can agree.
The MPS and Delivery Promises
The MPS provides a plan by which delivery promises can be made to customers.
As orders are received, they "consume" the available MPS.

Any part of the plan that is not consumed by actual customer orders is available to promise to
customers.
In this way the MPS provides a realistic basis for making delivery promises.
Using the MPS, sales and distribution can determine the available to promise (ATP).
Available to promise is that portion of a firm‘s inventory or production that is not already
committed and is available to the customer. This allows delivery promises to be made and
customer orders and deliveries to be scheduled accurately.
The ATP is calculated by adding scheduled receipts to the beginning inventory and then
subtracting actual orders that are scheduled before the next scheduled receipt. A scheduled receipt
is an order that has been issued either to manufacturing or to a vendor.
Time Fences
Changes to the master production schedule will occur. For example:
Customers cancel or change orders.
Machines break down or new machines are added, changing capacity.
Vendors have problems and miss delivery dates.
Processes create more scrap than expected.
A company wants to minimize the cost of manufacture and at the same time be flexible enough to
adapt to changing needs.
Changes to production schedules can result in the following:
 Cost increases due to rerouting, rescheduling, extra setups, expediting, and buildup of work-
in-progress inventory.
 Decreased customer service. A change in quantity of delivery can disrupt the schedule of
other orders.
 Loss of credibility for the MPS and the planning process.
Changes far out in the planning horizon can be made with little or no cost or disruption to
manufacturing, but the nearer to delivery, the more disruptive and costly changes will be.
To help in the decision-making process, companies establish zones divided by time fences.
Time Fence Zones

Frozen zone. Capacity and materials are committed to specific orders. Since changes would result
in excessive costs, reduced manufacturing efficiency, and poor overall customer service, senior
management approval is usually required to make a change.
Slushy zone. Capacity and material are committed to a reduced extent. This is an area for trade-
offs that must be negotiated between marketing and manufacturing. If material and capacity are
available, then changes can be made. If not, then perhaps other orders can be shifted.
Liquid zone. Any change can be made to the MPS as long as it is within the limits set by the
production plan. Changes are routine and often are made by the computer program.
Summary
The master production schedule (MPS) is a plan for the production of individual end items.
The MPS must match demand for the product in total, but it is not a forecast of demand.
The MPS must be realistic. It must be able to be achieved and must reflect a balance between
required and available capacity.
The MPS is the meeting ground for sales and production.
The MPS provides a plan from which delivery promises can be made to customers.
If adjustments have to be made in deliveries or the booking of orders, they are done through the
MPS.
Major MPS functions include:
To form the link between production planning and what manufacturing builds.
To plan capacity requirements. The master production schedule determines the capacity that is
required.
To plan material requirements. The MPS drives the material requirements plan.
To keep priorities valid. The MPS is a priority plan for manufacturing.
To aid in making order promises. The MPS is a plan for what is to be produced and when.
To be a contract between marketing and manufacturing. It is an agreed-upon plan.
The MPS must be realistic and based on what production can and will do. If it is not, the results
will be as follows:
Overload or under load of plant resources

Unreliable schedules resulting in poor delivery performance
High levels of work-in-process (WIP) inventory
Poor Customer Service
Loss of credibility of the planning system
Material Requirements Planning

Manufactured end items are fabricated or assembled from components that must be available in
the right quantities and at the right time to meet the requirements of the MPS.
If any component is missing, the product cannot be built and shipped on time.
A system is needed to plan the requirements for these components.
Material Requirements Planning (MRP) does this.
MRP establishes a schedule (priority plan) showing the components required at each level of the
assembly and, on the basis of lead times, calculates the time when these components will be
needed.
We will discuss bills of material (the major building block of MRP), the MRP process, and how
the material requirements plan is used
Nature of Demand
There are two types of demand, independent and dependent.
Independent demand is not related to the demand for any other product. For example if a
company makes wooden tables the demand for the tables is independent. Master production
schedule items are independent demand items.
The demand for the sides, ends, legs, and top depends on the demand for the tables, and these are
dependent demand items.
Since independent demand is not related to the demand for any other assemblies or products, it
must be forecasted.
Items shown on an MPS are independent demand.
Since dependent demand is derived or directly related to the demand for higher level assemblies
or products, it can be calculated.
Material requirements planning is designed to do this calculation.
An item can have both a dependent and an independent demand.
A service or replacement part has both.
The manufacturer of vacuum cleaners uses flexible hose in the assembly of the units. In the
assembly of the vacuums the hose is a dependent demand item. However, the hose has a nasty
habit of breaking and the manufacturer must have replacement hoses available. Demand for
replacement hoses is independent since demand for them does not depend directly upon the
number of vacuums manufactured.

Objectives of MRP
Determine requirements
The main objective of any manufacturing planning and control system is to have the right
materials in the right quantities available at the right time to meet the demand for the firm's
products.
The MRP's objective is to determine what components are needed in order to meet the master
production schedule and, on the basis of lead time, to calculate the time periods when the
components must be available. It must then determine What to order, How much to order, When
to order, and When to schedule delivery.
It is a constant chore to keep priorities current
 The demand for and supply of components change daily.

 Customers enter or change orders.
 Components get used up.
 Vendors are late with delivery.
 Scrap occurs.
 Orders are completed.
 Machines break down.
In this ever-changing world, an MRP must be able to reorganize priorities to keep plans current.
AN MRP must be able to add and delete, expedite, delay, and change orders.
Linkages to Other MPC Functions
The MRP is driven by the MPS.
The MRP is a priority plan for the components needed to make the products in the MPS.
The MRP will be a valid plan if the capacity is available when needed to make the components.
The MRP must be checked against capacity. The process of doing so is called capacity
requirements planning (discussed later).
MRP in turn drives, or is input to, production activity control (PAC) and purchasing.
MRP plans the release and receipt dates for orders.
It is the job of PAC and purchasing to plan and control the performance of the orders to meet the
job dates.
The Computer

If a company makes a small number of simple products, it might be possible to perform material
requirements planning manually.
However, most companies need to keep track of thousands of components in a world of changing
demand, supply, and capacity.
In the days before computers it was necessary to maintain extensive manual systems and to have
large inventories and long lead times.
These were needed as a cushion due to the lack of accurate and up-to-date information and the
inability to perform the necessary calculations quickly.
Somehow, someone in the organization figured out what was required sooner, or very often later,
than needed.
"Get it early and get lots of it!!" was a good rule then
Computers are incredibly fast and accurate and ideally suited for the job at hand.
With their ability to store and manipulate data and produce information rapidly, manufacturing
now has a tool to use modern manufacturing planning and control systems properly.
There are many application programs available that will perform the calculations needed in MRP
systems.
Inputs to the MRP System
1. Master Production Schedule
2. Inventory Records
3. Bills of Material
Master Production Schedule
A statement of which end items are to be produced, the quantity of each, and the dates they are to
be completed.
Drives the MRP system by providing the initial input as to what components are required to the
MRP system can produce orders for manufactured and purchased parts and raw materials.
Inventory Records
A major input to the MRP system is inventory.

When a calculation is made to find out how many are needed, the quantities on hand must be
taken into account.
There are two kinds of information needed.
1. Planning Factors—order quantities, lead times, safety stock, and scrap.

2. Status of Each Item---MRP needs to know how much is on hand, how much is allocated, and
how much is available for future demand.
These data are maintained in an inventory record file (also called a part master file or item master
file).
Each item has a record and all the records together form the file.
Bills of Material
If we want to make something, the first question to ask is "What is it Made of?"
Recipes, formulas, and parts lists tell us what is needed to make the end product----all are bills of
material.
A bill of materials is a listing of all the components and parts required to make one of an
assembly.
Bills of Materials—Important Points
The Bill of Material shows all the parts required to make one of the items.
Each part of items has only one part number. A particular number is unique to one part and is
not assigned to any other part. Thus, if a particular number appears on two different bills of
material, then the part so identified is the same.
Product Tree
The bill of material can more conveniently be shown as a product tree (sometimes called a family
tree)
A bill of material is one of the most widely used documents in a manufacturing (or construction)
company.
Bills of Material--Uses
Product Definition. The bill specifies the components needed to make the product.
Engineering Change Control. Product design engineers sometimes change the design of a
product and the components that are used. These changes must be recorded and controlled. The
bill provides the method for doing so.

Service Parts. Replacement parts needed to repair a broken component are determined from the
bill of material
Planning. Bills of material define what materials have to be scheduled to make the end product.
They define what components have to be purchased and made to satisfy the master production
schedule.
Order Entry. Where a product has a very large number of options (E.g.. cars), the order entry
system very often configures the end product bill of materials. The bill can also be used to price
the product
Manufacturing. The bill provides a list of the parts needed to make or assemble a product
Costing. Product cost is usually broken down into direct material, direct labor, and overhead.
The bill provides not only a method of determining direct material but also a structure for
recording direct labor and distributing overhead
Bills of Material---Importance
There is hardly a department of the company that will not make some use of the bill at some time.
Maintaining bills of material and their accuracy is extremely important.
The computer is an excellent tool for centrally maintaining bills and for updating them.
Types of Bills of Material
Parts list. It lists all the parts that are needed to make one of the assembly. The parts list is
produced by the product design engineer and does not necessarily reflect the way the parts go
together or any subassemblies that might be made.
Multilevel BOM. This BOM reflects the way in which the product will be manufactured. It
shows the grouping of parts into subassemblies and components. It is the responsibility of
manufacturing engineering to decide how the product is to be made, the operations to be
performed, their sequence, and their grouping. The subassemblies that have been created are the
result of this.
Indented bill of material. A multilevel bill of material can also be shown as an indented bill of
material.
This bill uses indentations as a way of differentiating parents from components.
The components of the parent are listed in the first column, The components of those components
are listed in the second column, etc.

Components are linked to their parents by indenting the columns and by listing them immediately
below the parent.
Single-level BOM. A single-level bill of material contains only the parent and its immediate
components, which is why it is called a single-level bill.
The computer stores information describing the product structure as a single-level bill.
A series of single-level bills is needed to completely define a product.
"Where-Used" and "Pegging" Reports
"Where-used" report. A component may be used in making several parents. Wheels on an

automobile, example, might be used on several models or cars. A listing of all the parents in
which a component is used is called a "where-used" report. This has several uses, such as in
implementing an engineering change, or when materials are scarce, or in costing a product.
"Pegging" report. A "pegging" report is similar to a "where-used" report. However, while the
where-used report shows all parents for a component. The "pegging" report shows only those
parents for which there is an existing requirement.
"Pegging" Reports-Contents
1. The parents creating the demand for the components.

2. The quantities needed.
3. When items are needed.
MRP Process
Each component shown on the bill of material is planned for by the material requirements
planning system.
For convenience it is assumed that each component will go into inventory and be accounted for.
Whether the components actually go into a physical inventory or not is not important. However, it
is important to realize that planning and control take place for each component as they appear on
the bill.
Raw material may go through several operations before it is processed and ready for assembly, or
there may be several assembly operations between components and parent.
These operations are planned for, and controlled, by production activity control and not material
requirements planning.
The purpose of MRP is to determine the components needed, their quantities, and when they will
be needed so items in the master production schedule are made in time.

Exploding and Offsetting
The process of multiplying the requirements by the usage quantity and recording the appropriate
requirements throughout the product tree is known as exploding the requirements, or simply
exploding.
The process of placing exploded requirements in their proper time periods on the basis of lead
times is known as offsetting. (Lead time is the time from when an order is placed until the part is
available For use. It includes all times for ordering, processing the part, queuing, moving, and
expected delays).
Planned orders
Planned order receipt is the date when components must be received.
Planned order release is the date when the order for the components must be issued.
Gross and Net Requirements
If inventory is available, it must be taken into account.
Gross requirements minus inventory equal net requirements.
The planned order release of the parent becomes the gross requirement of the component.
Released Orders
So far we have looked at the process of planning when orders should be released so work is done
in time to meet requirements.
Requirements change, and in many cases on a daily basis.
A computer-based material requirements planning system automatically recalculates the

requirements for subassemblies and components and recreates planned order releases to meet the
shifts in demand.
Planned order releases have not been released. They must be released by a material planner.
Since the objective of the MRP id to have material available when it is needed and not before,
orders for material should not be released until the planned order release date arrives.
This means that an order is not normally released until the planned order is in the current week.
Before a manufacturing order is released, component availability must be checked.
The computer program checks the component inventory records to be sure that enough material is
available and, if it is, allocates the necessary quantity to that work order.

When the authorization to purchase or manufacture is released, the planned order receipt is
canceled and a Scheduled receipt is created in its place.
Scheduled receipts
Scheduled receipts are orders placed on manufacturing or on a vendor and represent a

commitment.
For an order in a factory necessary materials are committed and capacity at work centers allocated
to that order.
For purchased parts similar commitments are made to the vendor.
The scheduled receipts row shows the quantities that have been ordered and when they are
expected to be completed and available.
Open orders
Scheduled receipts on the MRP record are open orders on the factory or a vendor.
They are the responsibility of purchasing and of production activity control.
When the goods are received into inventory and available for use, the order is closed out and the
scheduled receipt disappears to become part of the on-hand inventory.
Net requirements
The calculation for net requirements can now be modified to include scheduled receipts: Net
requirements = gross requirements - scheduled receipts - available inventory
Basic MRP Record Components
The current time is the beginning of the first period.
Time periods are called time buckets. They are often a week but can be any length of time
convenient to the company. Some companies are moving to daily time buckets.
The number of periods in the record is called the planning horizon which shows the number of
future periods for which plans are being made. It should be at least as long as the cumulative
product lead time; otherwise the MRP system is not able to release planned orders of items at the
lower level at the correct time.
An item is considered to be available at the beginning of the time bucket in which it is required.
The quantity shown in a projected on-hand row is the projected on-hand balance at the end of the
period.

The immediate or most current period is called the action bucket. A quantity in the action bucket
means that some action is needed now to avoid a future problem.
Capacity Requirements Planning
As occurred in the previous planning levels, the MRP priority plan must be checked against
available capacity.
At the MRP planning level the process is called capacity requirements planning (CRP).
If the capacity is available, then the plan can proceed. If not, then either capacity has to be made
available or the priority plans have to be changed.
Low-Level Coding and Netting
A component may reside on more than one level in a bill of material.
If this is the case, it is necessary to make sure that all gross requirements for that component have
been recorded before netting takes place.
The process of collecting the gross requirements and netting can be simplified by using low-level
codes. The low-level code is the lowest level on which an item resides in all bills of material.
Every item has only one low-level code
Low-level codes can be determined by starting at the lowest level of a bill of material and,
working up, recording the level against the item.
If an item occurs on a higher level, its existence on the lower level has already been recorded.
Once the low-level codes are obtained, the net requirements for each item can be calculated using
the following procedure
Netting Procedure
STEP 1: Starting at level 0 of the tree, determine if any of the items on that level have a low-
level code of 0. If so, those items occur at no lower level and all the gross requirements have
been recorded. These items can therefore be netted and exploded down to the next level, that is,
into their components. If the low-level code is greater than zero, then there are more gross
requirements and the item is not netted.
STEP 2: Move down to level I on the product tree and repeat the routine followed in step 1.
STEP 3: Move down to level 2 on the product tree and repeat the routine in steps 1 and 2.
Multiple Bills of Material

Most companies make more than one product and often use the same components in a number of
their products.
The material requirements planning system will gather the planned order releases from all the
parents and will create a schedule of gross requirements for the components.
The same procedure used for a single bill of material can be used where there are multiple
products being manufactured.
All bills must be netted and exploded level by level as was done for a single bill.
Using the Material Requirements Plan (MRP)
The MRP software will perform all the calculations we have done so far.
 It will net, offset, and explode requirements and create planned order releases.
 It will keep priorities current for all planned orders according to changes in gross
requirements for the part.
 It will not issue a purchase or manufacturing order or reschedule open orders.
 It will print action or exception messages suggesting that the planner should act and what
kind of action might be appropriate.
It is the planner's responsibility to issue orders and to reschedule existing orders as required.
Planners are also responsible for working with other planners, master production schedulers,
production activity control, and purchasing to solve problems as they arise.
Types of Orders
Planned Orders
Automatically scheduled and controlled by the computer.
As gross requirements, projected available inventory, and scheduled receipts change, the
computer will recalculate the timing and quantities of planned order releases.
The MRP program will recommend to the planner the release of an order when the order enters
the action bucket but will not of itself release the order.
Released orders
Releasing a planned order is the responsibility of the planner.
When that is done the order becomes an open order to the factory or to purchasing and appears on
the MRP and appears on the MRP record as a scheduled receipt.
It is under control of the planner who may expedite, delay or even cancel the order.

Firm Planned Orders
The computer-based MRP system automatically recalculates planned orders as the gross
requirements change.
At times the planner may wish to hold a planned order firm against changes in quantity and time
despite what the computer may calculate.
This might be necessary because of future availability of material or capacity or to handle special
demands on the system.
The planner can tell the computer that the order is not to be changed unless the planner advises
the computer to do so.
The order is ''firmed'' against the logic of the computer.
Material Requirements Planners must manage the parts for which they are responsible—this
means not only releasing orders to purchasing and the factory, rescheduling due dates of open
orders, and reconciling differences and inconsistencies but also finding ways to improve the
system and removing the causes of potential errors.
Capacity Management
So far we have been concerned with planning priority, that is, determining what is to be produced
and when
The system is hierarchical, moving from relatively long planning horizons and little detail
(production plan) through medium time spans (master production schedule) to a high level of
detail and relatively short time spans (material requirements plan).
At each of the levels manufacturing has developed priority plans to satisfy demand, and it has had
to balance priority and capacity to get a workable plan.
Capacity management is responsible for determining the capacity needed to achieve the priority
plans and with providing, monitoring, and controlling that capacity so the priority plan can be met
Capacity Management consists of two phases:
1. Capacity planning
2. Capacity control
Capacity Planning
The process of determining the resources required to meet the priority plan and with methods of
making that capacity available.

Takes place at each level of the priority planning process.
Production planning, master production scheduling, and material requirements planning

determine priorities: what is wanted and when
Capacity planning links the various production priority schedules to manufacturing resources.
Concerned with determining the capacity needed to achieve the priority plan and with the ways of
making that capacity available.
If the capacity cannot be made available, then the priority plans have to be changed.
Priority plans are usually stated in units of product or some standard unit of output.
Capacity can sometimes be stated in the same units, for example, tons of steel or yards of cloth.
At other times there is no common unit, and capacity has to be stated as the hours available.
In these cases the priority plan must be translated into hours of work required and then compared
to the hours available.
For these cases, the process of capacity planning is as follows:
Determine the capacity available at each work center.

Translate the priority plan into the hours of work required at each work center in each time period.
Sum up the capacities required for each item on each work center to determine the load on each
work center in each time period.
Adjust available capacity, if possible, to match the load. Otherwise change the priority plans to
match the available capacity Planning Levels.
Capacity Control
The process of monitoring production output, comparing it with the capacity plans, and taking
corrective action as needed.
Discussed under the subject of production activity control.
Planning Levels
Resource Planning
Concerned with long-range capacity resource requirements and is directly linked to production
planning.
Typically it involves translating monthly, quarterly, or annual product priorities from the
production plan into some total measure of capacity such as gross labor hours.

It involves changes in manpower, capital equipment, product design, or other facilities that take a
long time to acquire and dispose of.
If a resource plan cannot be devised to meet the production plan, then the production plan has to
be changed.
The two plans set the limits and levels for production, and if they are realistic, then it should be
possible to carry out the master production schedule.
Rough Cut Capacity Planning
Takes capacity planning to the next level of detail.
The master production schedule is the primary information source.
The purpose of rough-cut capacity planning is to check the feasibility of the MPS, provide
warning of any bottlenecks, ensure utilization of work centers, and advise vendors of capacity
requirements.
Directly linked to the material requirements plan.
Since it is concerned with component parts, it is in greater detail than rough-cut capacity planning.
It is concerned with individual orders at individual work centers and calculates work center loads
and labor requirements for each time period at each work center.
Available Capacity
Capacity is the ability to produce work.
The American Production and Inventory Control Society (APICS Dictionary, 6th ed.) defines
capacity as "the highest reasonable output rate which can be achieved with current product
specifications, product mix, work effort, plant and equipment."
This definition can be applied to an individual work center, a department, or a plant--emphasis is

on the number of units of product that can be produced in a given time.

Factors Affecting Available Capacity
 Product specification--If the product specifications change, the work content (work required
to make the product) will change, thus affecting the number of units that can be produced.
 Product mix--Each product has its own work content measured in the time it takes to make
the product. If the mix of products being produced changes, then the total work content (time)
for the mix will change.
 Work effort—this relates to the speed or pace at which the work is done. If the work force
changes pace, for example, produces more in a given time, then the capacity will be altered.
 Plant and equipment--This relates to the methods used to make the product. If the method is
changed, for example, a faster machine is used, then the output will change. Similarly, if
more machines are added to the work center, the capacity will change.
Unit of Measurement
Where the variety of products produced at a work center or in a plant are not large, it is often
possible to use a unit common to all products.
Paper mills speak of capacity in tons of paper, breweries in barrels of beer, and automobile
manufacturers in numbers of cars.
However, where a variety of products is made, it may be that a good common unit does not exist.
In this case the unit common to all products is time.
The work content of a product is expressed as the time required to make the product using a given
method of manufacture.
Using time study techniques, the standard time for a job can be determined. This is the time we
would expect a qualified operator working at a normal pace to take to do the job, It provides a
yardstick for measuring work content and a unit for stating capacity. It is also used in talking
about loading and scheduling.
Levels of Capacity
1. Machine or individual worker

2. Work center--A work center is composed of a number of machines or workers capable of
doing the same work
3. Plant--A plant can be considered as a group of different work centers.
Determining Available Time
The available time of a work center is dependent on the number of machines, the number of
workers, and the hours of operation.

If a work center has three machines and is operated for 8 hours a day 5 days a week, then
available time = 3 x 8 x 5 = 120 hours per week
Utilization
Available time is the maximum actual hours we could expect from the work center.
However, it is unlikely this will be achieved all the time
Downtime can occur due to machine breakdown, absenteeism, lack of material, and so on, all
those things that cause unavoidable delays.
The percentage of time that the work center is active compared to the available time is called
work center utilization:.
Utilization = hours actually worked X 100% available hours
For example, suppose that a work center has available time of 120 hours but actually produced
goods for 100 hours:
Utilization = 100 = 83.3%

120
Utilization can be determined from historical records or by a work sampling study.
Efficiency
It is possible for a work center to utilize 100 hours a week but not produce 100 standard hours of
work.
Workers might be working at a faster or slower pace than the standard working pace, causing the
efficiency of the work center to be more or less than 100%:
Efficiency = std hours of work produced X 100

hours actually worked
Rated Capacity
Rated capacity is calculated by taking into account work center utilization and efficiency.
Rated capacity = available time x utilization x efficiency
For example, suppose a work center consists of four machines and is operated 8 hours per day for
5 days a week. Historically the utilization has been 85% and the efficiency 110%. What is the
rated capacity?
Available time = 4 x 8 x 5 = 160 hours per week
Rated capacity = 160 x 0.85 x 1.10 = 149.6 standard hours

Demonstrated Capacity
Capacity can also be measured.
Measured, or demonstrated, capacity is determined from historical data.
For example, suppose that over a 4-week period a particular work center produced 220 standard
hours of work. The demonstrated capacity is 220/4 = 55 standard hours of work per week.
Required Capacity
Capacity requirements are generated by the priority planning system and involve a translation of
the priorities, given in units of product or some common unit, into the hours of work required at
each work center in each time period.
This translation must take place at each of the priority planning levels from production planning
to master production scheduling to material requirements planning.
There is thus a direct link between the various levels of priority planning and capacity planning.
The Capacity Requirements Plan (CRP) occurs at the level of the MRP.
It takes planned orders from the MRP and open-shop orders (scheduled receipts) and converts
these into demand for time in each work center in each time period.
It takes into consideration lead times for operations and offsets the operations at work centers
accordingly.
In considering open-shop orders, it accounts for work already done on a shop order.
The most detailed, complete, and accurate of the capacity planning techniques.
This accuracy is most important in the immediate time periods.
Because of the detail, the data and computation required are great.
Inputs
Inputs needed for a CRP are open-shop orders, planned order releases, routings, time standards,
lead times, and work center capacities. This information can be obtained from:
 Open order file

 Material requirements plan
 Routing file

 Work center file
Open Order file
An open-shop order appears as a scheduled receipt on the MRP.
It is a released order for a quantity of a part to be manufactured and completed on a specific date.
It shows all relevant information such as quantities, due dates, and operations.
The open-order file is a record of all the active shop orders.
It can be maintained manually or as a computer file.
Planned Order Releases
Planned orders are determined by the computer's MRP logic based upon the gross requirements
for a particular part.
They are inputs to the CRP process in determining the total capacity required in future time
periods.
Routing File
A routing is the path that work follows from work center to work center as it is completed.
Routing is specified on a route sheet or, in a computer-based system, in a route file.
One should exist for every component manufactured and contain the following:
 Operations to be performed
 Sequence of operations
 Work centers to be used
 Possible alternate work centers
 Tooling needed at each operation
 Standard times: setup times and run times per piece.
Work Center File
A work center is a particular production facility of one or more machines and/or people each of
which performs the same functions and has the same capacity.
A work center file contains information on capacity and move, wait, and queue times.
Move time is time taken to move material from one work station to another.
Wait time is time a job is at a work center after completion and before being moved.
Queue time is time a job waits at a work center before being worked on.
Lead time is sum of queue, setup, run, wait, and move times

Shop Calendar
Another piece of information that is needed is the number of working days available.
The Gregorian calendar (which is the one we use every day) has some serious drawbacks for
manufacturing planning and control.
The months do not have the same number of days, holidays are spread unevenly throughout the
year, and it does not work on a decimal base.
Julian (or other calendars) are generally preferred.
Scheduling Orders
The first step in capacity requirements planning is to determine when orders must be started and
completed on each work center so the final due date can be met.
This process is called scheduling.
The usual process is to start with the due date and, using the lead times, to work backward to find
the start date for each operation. This process is called backward scheduling.
Information needed for backward scheduling is obtained from the following:
1. Order file--Quantities and due dates

2. Route file--Sequence of operations, work centers needed, setup time, and run time
3. Work center file--Queue, move, and wait times and work center capacity
You can calculate the work (time) to be done at each work center for a particular order: Setup
time + run time = total time (standard hours)
We schedule back from the schedule due date to get the completion and start dates for each
operation.
To do so, we need to know not only the operation times but also the queue, wait, and move times,
which are in the work center file.
Calculate the work (time) to be done at each work center for a particular order.
We can now back-schedule from the due date to get the completion and start dates for each
operation
A scheduling rule should be established to convert the operation times in standard hours into days,
the same units as the other times

Load Profiles
We have developed a schedule of start and finish dates for each work center.
The next task is to develop a load profile for each work center showing the capacity requirements
based on planned and released orders for each time period of the plan. To do this, we determine
the standard hours of operation time for each order for each work center by time periods, and then
add all the standard hours together for each work center in each time period.
The result is the total required capacity (load) on that work center for each time period of the plan.
Making the Plan
The next step is to compare the load to available capacity to see if there are imbalances and, if so,
to find possible solutions.
In general, there are two ways of balancing available capacity and load: alter the load or change
the available capacity.
Alter the load
Means shifting orders ahead or back so the load is leveled.
If orders are processed on other work stations, the schedule and load on the other work stations
have to be changed as well.
It may also mean that other components should be rescheduled and the master production
schedule changed.
Changing the load may not be the preferred course of action.
 Change the Available Capacity (In the Short Run)

 Schedule overtime or under time.
 Adjust the level of the work force by hiring or laying off workers.
 Shift work force from under loaded to overloaded work centers.
 Use alternate routings to balance load over work centers.
 Subcontract work when more capacity is needed or bring in previously subcontracted work to
increase required capacity.
Production Activity Control
The time comes when plans must be put into action.
Production Activity Control (PAC) is responsible for executing the master production schedule
and the material requirements plan.

While doing so it must make good use of labor and machines, minimize work-in-process
inventory, and maintain customer service.
The material requirements plan authorizes production activity control to release work orders to
the shop for manufacturing.
Production activity control is responsible for taking control of the work order and making sure
that it is completed on time.
It is responsible for the very short-term detailed planning of the Flow of orders through
manufacturing, implementing the plan, and controlling the work as it progresses to final
completion.
It must manage the day-to-day activity and the detail needed to do so.
PAC activities include planning, implementation, and control.
Planning
The flow of work through each of the work centers has to be planned so the delivery dates can be
met. This will require PAC to do the following:
Ensure that the required materials, tooling, personnel, and information are available to
manufacture
Schedule start and completion dates for each shop order at each work center so the scheduled
completion date of the order can be met. To do this will involve the planner in developing a load
profile for the work centers
Implementation
Once the plans are made, they must be put into action by advising the shop floor as to what is to
be done.
This is usually done through some form of shop order. Production activity control will:
1. Gather together the information needed by the shop floor to make the product.
2. Release orders to the shop floor as authorized by the material requirements plan. This is
called dispatching.
Control
Once plans are made and shop orders released, the process must be monitored to see what is
actually happening.
This is then compared to the plan to determine whether corrective action is necessary.
Production Activity Control Functions

Rank shop orders in desired priority sequence by work center and, on this basis, establish a
dispatch list.
Track actual performance of work orders and compare to planned schedules
Where necessary, PAC must take corrective action by re-planning, rescheduling, or adjusting
capacity to meet final delivery requirements
Monitor and control work in process, lead times, and work center queues.
Report work center efficiency, operation times, order quantities, and scrap.
Manufacturing Systems
The particular type of production control system used will vary from company to company, but
all should perform the preceding functions.
The relative importance of these functions will vary depending on the type of manufacturing
process:
1. Line Flow manufacturing

2. Intermittent manufacturing
3. Project manufacturing
Line Flow Manufacturing
Routings are fixed and work centers are arranged according to the routing. time taken to perform
work at one work center is almost the same as any other work center in the line
Work centers are dedicated to produce a limited range of similar products. Machinery and tooling
are especially designed to make the specific products.
Material flows from one work station to another using mechanical transfer. There is little buildup
in work-in-progress inventory and throughput times are relatively low.
Capacity is fixed by the line.
Production activity control concentrates on planning the flow of work and making sure that the
right material is fed to the line as determined by the planned schedule.
Since work flows from one work station to another automatically, implementation and control are
relatively simple.
Intermittent Manufacturing
Flow of work through the shop is varied and depends on the design of a particular product. The
time an order takes at any one work center is different from another and the work flow is not
balanced.

Machinery and workers must be flexible to do the variety of work. Machinery and work centers
are usually grouped according to the function they perform (e.g., all lathes in one department).
Throughput times are generally long. It is difficult to schedule work to arrive just when needed,
the time taken by an order at each work center is the same, and work tends to queue up before
work centers, causing long delays in processing. Work-in-Process inventory is often large.
The capacity required depends on the particular mix of products being built and is difficult to
predict
Production activity control in intermittent manufacturing is complex.
Because of the number of products made, the variety of routings, and scheduling problems, PAC
is a major activity in this type of manufacturing.
Planning and control are typically exercised using shop orders for each batch being produced.
Project Manufacturing
Associated with the manufacture of one or a small number of units. Large-ship building is an
example. Because the design of the product is often modified, or done, as the project moves along,
there is close coordination between manufacturing, marketing, purchasing, and engineering.
The production plan, often using network analysis, is the most important Function and determines
when activities are to he performed.
Data Requirements
To plan the processing of materials through manufacturing, PAC must know the following:
 What and how many to produce.
 When parts are needed so the final completion date can be met.
 What operations are needed to make the product and the times the operations will take.
 Available capacities of the various work centers.
The PAC must have a data or information system from which to work.
The data needed to answer these questions is organized into a data base. The files contained in the
data base are of two types, planning and control.
 Planning Files
 Item master file

 Product structure
 Routing file
 Work center master file

Item Master File
There is one record in this file for each part number, consisting of:
 Part number, a unique number assigned to a component

 Part description
 Manufacturing lead time, the normal time needed to make this part
 Quantity on hand
 Allocated quantity, quantities assigned to specific work orders but not yet withdrawn from
inventory
 On-order quantities, the balance due on all outstanding orders
 Lot size quantity, the quantity normally ordered at one time
Product Structure File (Bill of Material File)
Contains a list of the single-level components and quantities needed to assemble a parent.
Forms a basis for a pick list to be used by storeroom personnel to collect the parts required to
make the assembly.
Routing File
There is a record in this file for each part manufactured.
The routing consists of a series of operations required to make the item.
For each product this file contains a step-by-step set of instructions describing how the product is
made. It includes:
1. The operations required to make the product and the sequence in which those operations are
to be performed.
2. A brief description of each operation.
3. Equipment, tools, and accessories needed for each operation.
4. Setup times: the standard time required for setting up the equipment for each operation
5. Run times: the standard time to process one unit through each operation.
6. Lead times for each operation.
Work Center Master File
The purpose of this file is to collect all the relevant data on a work center. For each work center it
gives details on the following.
 Work center number

 Capacity. a. Number of shifts worked per week. b. Number of machine hours per shift. c.
Number of labor hours per shift
 Efficiency
 Utilization

 Queue time, the average time that a job waits at the work center before work is begun
 Alternate work centers: work centers that may be used as alternatives
Control in Intermittent Manufacturing
Exercised through shop orders and control files that contain data on these orders.
Generally two kinds of files:
1. Shop order master file.

2. Shop order detail file.
Shop Order Master File
Each active manufacturing order has a record in this file. Normally contains:
 Shop order number: a unique number identifying the shop order

 Order quantity
 Quantity completed
 Quantity scrapped
 Quantity of material issued to the order
 Due date, the date the order is expected to be finished
 Priority, a value used to rank the order in relation to others
 Balance due, the quantity as yet not completed
 Cost information
Shop Order Detail File
Each shop order has a detail file, and that file contains a record for each operation needed to make
the item. Each record contains the following information:
 Operation number
 Setup hours, planned and actual
 Run hours, planned and actual
 Quantity reported complete at that operation
 Quantity reported scrapped at that operation
 Due date or lead time remaining
Order Preparation
Once authorization has been received to process an order, it is the responsibility of PAC to plan
and prepare its release to the shop floor.
The order should be reviewed to be sure that the necessary tooling, material, and capacity are
available. If they are not, the order cannot be completed and should not be released

Tooling is not generally considered in the MRP program, and at this stage its availability must be
checked.
The MRP software program will have checked the availability of material and allocated it to a
shop order so it may not be necessary to check.
If MRP has not been used, Then PAC will have to manually check material availability.
If a capacity requirements planning system has been used, then it is expected that capacity is
available.
At this stage there may be some differences between planned capacity and what is actually
available.
When CRP is not used it is necessary to check to see if capacity is available.
Checking capacity availability is a two-step process
1. The order must be scheduled to see when the capacity is needed

2. The load on work centers must be checked in that time period
Scheduling
Objective is to meet delivery dates and to make the best use of manufacturing resources.
It involves establishing start and finish dates for each operation required to complete an item.
To develop a reliable schedule, the planner must have information on routing, required and
available capacity, competing jobs, and manufacturing lead times (MLTs ) at each work center
involved,
Manufacturing Lead Time
This is the time normally required to produce an item in a typical lot quantity. Typically MLT is
made up of five elements:
1. Queue time, time the job is waiting at a work center before operation begins
2. Setup time, time required to prepare the work center for operation
3. Run time, time to run the order through the operation
4. Wait time, time the job is at the work center before being moved to the next work center
5. Move time, transit time between work centers
The total MLT is the sum of the MLTs for each operation
Setup time and run time are fairly straightforward, and determining them is the responsibility of
the industrial engineering department.

Queue, wait, and move times are under the control of manufacturing and PAC.
Queue Time
The largest of the five elements is queue time.
Typically, in an intermittent manufacturing operation, it accounts for 85-95% of the total lead
time.
The queue can be managed by regulating the flow of work into and out of work centers, and it is
generally the responsibility of PAC to do so.
If the number of orders waiting to be worked on (load) were reduced, so would the queue time,
the lead time, and the work in process.
Increasing capacity would also reduce queue.
It is the job of production activity control to manage both the input of orders to the production
process and the capacity available so queue and work in process are controlled.
There are many techniques to schedule shop orders through a plant, but all of them require an
understanding of forward and backward scheduling and of finite and infinite loading.
Scheduling Techniques
Forward Scheduling
Assumes that material procurement and operation scheduling for a part starts as soon as the order
is received regardless of the due date, and that operations are scheduled forward from this point.
Backward Scheduling
The last operation on the routing is scheduled first, and it is scheduled for completion at the due
date.
Previous operations are scheduled back from the last operation.
This schedules items to be available as needed and is the same logic as used in the MRP system.
Work-in-process inventory is reduced, but because there is little slack time in the system,
customer service may suffer.
Backward scheduling is the most common in industry because it reduces inventory.
Infinite loading

Here The assumption is made that the work stations on which operations are done will have the
capacity available when required.
It does not consider the existence of other shop orders competing for capacity at these work
centers.
It assumes infinite capacity will be available.
Finite Loading
Assumes there is a defined limit to available capacity at any work station.
If there is not enough capacity available at a work station because of other shop orders, then the
order has to be scheduled in a different time period.
Operation Overlapping
A technique used to reduce the total MLT by cutting out the queue and transit times between
operations
An order is divided into at least two lots. As soon as the first lot is completed on operation A it is
transferred to operation B. While operation A continues with the second lot. operation B starts on
the first lot. When operation A finishes the second lot it is transferred to operation B. If the lots
are sized properly there will be no idle time at operation B. The total MLT is reduced by the
overlap time and the elimination of queue time.
Operation Splitting
Operation splitting is a second method of reducing MLT.
The order is split into two or more lots and run on two or more machines at the same time.
If the lot is split in two the run time component of lead time is effectively cut in half even though
an additional setup is incurred.
Load Leveling
The load profile for a work center can be constructed by determining the standard hours of
operation for each order in each time period and adding them together by time period.
Scheduling Bottlenecks
In intermittent manufacturing it is almost impossible to balance the available capacities of the

various work stations with the demand for their capacity.
This means that some work stations are overloaded and some under loaded.

The overloaded work stations are called bottlenecks, and by definition are those work stations
where the required capacity is greater than the available capacity.
Bottlenecks control the throughput of all products that are processed by them.
Work centers that feed the bottlenecks are capable of producing more than the bottleneck can
process.
 If scheduled to their capacity, they build up excess work in process inventory
 They should be scheduled to feed the bottleneck at the rate that the bottleneck can process
 Work centers that are fed by bottlenecks have their throughput controlled by the bottleneck,
and their schedules should be determined by that of the bottleneck
“Theory of Constraints”
Eliyahu Goldratt and Robert Fox of the Avraham Y. Goldratt Institute have developed the
"Theory of Constraints," which explores the problems of constraints (bottlenecks), their effect on
a company's performance, and how they can be analyzed and overcome
They call a bottleneck a "Capacity Constraint Resource" (CCR)
In the race they state "that such a constraint will dictate the rate of production of the entire plant".
To effectively schedule the constraint, two things must be done.
STEP ONE is to establish a "time buffer" inventory (queue) before each CCR. This buffer
should contain only enough inventory to keep the CCR busy for a predetermined time. Since it is
of the utmost importance to keep the CCR working at all times, it must never be starved for
material. It can only be starved if the flow from feeding work stations is disrupted. The time
buffer should be only as long as the time of any expected delay caused by feeding work stations.
In this way the time buffer ensures that the CCR will not be shut down for lack of work and that
this queue will be held at a predetermined minimum quantity.
STEP TWO is to control the rate of material being fed to the CCR. It must be fed at a rate equal
to the CCR's available capacity so the time buffer neither increases nor decreases but is
maintained constant. The first operation in the sequence of operations is called a "gating
operation." Since this operation controls the work being fed to the CCR, its operation must be
sequenced at a rate equal to the output of the CCR so the time buffer queue is maintained.
Another name for this system is "Synchronized Manufacturing".
Implementation
Orders that have tooling, material, and capacity have a good chance of being completed on time
and can be released to the shop floor.

Those orders that do not should not be released.
If released, they only cause excess work-in-process inventory and perhaps work centers to work
on orders that cannot be completed instead of those that can.
Implementation is achieved by issuing a shop order to manufacturing authorizing them to go

ahead and make the item.
Contents of a “Shop Packet”
 Shop order showing the shop order number, the part number, name, and description and
quantity.
 Engineering drawings.
 Bills of material.
 Route sheets showing the operations to be performed, equipment and accessories needed,
materials to use, and the setup and run times.
 Material issue tickets that authorize manufacturing to get the required material from stores.
 Tool requisitions authorizing manufacturing to withdraw necessary tooling from the tool crib.
 Job tickets for each operation to be performed. As well as authorizing the individual
operations to be performed, they also can function as part of a reporting system. The worker
can log on and off the job using the job ticket, and it then becomes a record of that operation.
 Move tickets that authorize and direct the movement of work between operations.
Control
Once the work orders have been issued to manufacturing, their progress has to be controlled.
To control progress, performance has to be measured and compared to the plan.
If what is actually happening (what is measured) varies significantly from that planned, then
either the plans have to be changed or corrective action has to be taken to bring performance back
to plan.
Control of orders in a manufacturing system is achieved by the following:
Controlling the work going into and coming out of a work center. This is generally called input-
output control.
Setting the correct priority of orders to run at each work center.
Input/Output Control
Production activity control must balance the work going to and coming from different work
centers.
This has to be done so queue, work-in-process and lead times are controlled.

The input/output control system is designed to balance the input rate in hours with the output rate
so these will be controlled.
The input rate is controlled by the release of orders to the shop floor.
If the rate of input is increased queue work-in-process and lead times increase.
The output rate is controlled by increasing or decreasing the capacity of a work center.
Capacity change is a problem for manufacturing but it can be achieved by over- or under time
shifting workers and so forth.
To be able to control input/output there must be a plan and a way of comparing what is actually
happening to the plan.

Input/Output Report Contents
 Planned and actual inputs monitor the flow of work coming to the work center.
 Planned and actual outputs monitor the performance of the work center.
 Planned and actual backlogs monitor the queue and lead time performance.
Priority Control
The Material Requirements Planning system establishes proper need dates and quantities.
Over time these dates and quantities change.
Customers want deliveries changed

There are changes in deliveries of component parts either from vendors or internally as well as
scrap, shortages, overages, and so on.
Priorities change and the PAC system must be able to react to these changes by changing the
priorities of shop orders.
Dispatch Lists
Control of priorities is exercised through dispatch lists.
The dispatch list is the instrument of priority control.
It is a listing by operation of all the jobs available to be run at a work center with the jobs ranked
by rules involving relative priorities.
Contents of Dispatch List
It normally includes the following information and is updated and published at least daily:
 Plant, department, and work center

 Part number, shop order number, operation number, and operation description OF JOBS at
the work center
 Standard hours
 Priority information
 Jobs coming to the work center
Priority Rules
Ranking of jobs for the dispatch list is created through the application of priority rules.

There are many rules, some attempting to reduce work-in-process inventory, others attempting to
minimize the number of late orders or maximize the output of the work center.
None is perfect or will satisfy all objectives.
Two that are commonly used are due date by operation and critical ratio.
Due Date by Operation and Critical Ratio
Due Date by Operation implies that orders at a work center will be run in sequence of the
operation due dates.
Critical Ratio (CR) is an index of the relative priority of an order to other orders at a work center.
It is based on the ratio of time remaining to work remaining and is usually expressed as:
CR = due date - present date = actual time remaining

lead time remaining lead time remaining
Lead time remaining includes all elements of manufacturing lead time
Production Reporting
Production reporting provides feedback of what is actually happening on the plant floor.
It allows PAC to maintain valid records of on-hand and on-order balances, job status, shortages,
scrap, material shortages, and so forth.
Production activity control needs this information to establish proper priorities and to answer
questions regarding deliveries, shortages, and the status of orders.
Manufacturing management needs information to assist them in operating the plant.
Payroll needs information with which to pay the employees.
Data must be collected, sorted, and reported.
The particular data collected depends upon the needs of the various departments.
The methods of data collection vary
In some cases the operator reports the start and completion of an operation, order, movement, and
so on, using an on-line system directly reporting events as they occur via data terminals
In other cases the operator, supervisor, or timekeeper reports this information on an operation
reporting form included in the shop packet.
Information about inventory withdrawals and receipts must be reported as well.

Information Needed in Reports
 Order status
 Weekly input/output by department or work center
 Exception reports on such things as scrap, rework, and late shop orders
 Inventory status
 Performance summaries on order status, work center and department efficiencies, and so on
Forecasting
Forecasting is a prelude to planning.
Before making plans, an estimate must be made of what conditions will exist over some future
period.
How estimates are made, and with what accuracy, is another matter, but little can be done without
some form of estimation.
Forecasting must be done if one wishes to be in a position to meet the demands of the future.
Most firms cannot wait until orders are actually received before they start to plan what to produce.
Customers usually demand delivery in reasonable time, and manufacturers must anticipate future
demand for products or services and make plans to provide the capacity and resources to meet
that demand.
Firms must have the resources of labor and equipment available to meet demand.
Factors Influencing Demand
 General business and economic conditions.
 Competitive factors.
 Market trends such as changing demand.
 The firm's own plans for advertising. promotion, pricing, and product changes.
What Should Be Forecast?
 Business plan
 Production plan

 Master production schedule
Business Plan
Concerned with overall markets and direction of the economy over next 2-10 years or more.
Purpose is to provide time to plan for those things that take long to change.
For production the business plan should provide sufficient time for resource planning: plant
expansion, capital equipment purchase, and long lead time purchase items.
Level of detail is not high, and usually forecasts are in sales units, sales dollars, or capacity.
Forecasts and planning will probably be reviewed quarterly or yearly.
Production Plan
Concerned with manufacturing activity for the next 1-3 years.
For manufacturing it means forecasting those items needed for production planning, such as
budgets, manpower planning, long lead time procurement items, and overall inventory levels.
Forecasts are made for groups or families of products rather than specific end items.
Forecasts and plans will probably be reviewed monthly.
Master Production Schedule
Concerned with production activity from the present to a few months ahead.
Forecasts are made for individual items, as found on a master production schedule, individual
item inventory levels, raw materials and component parts, manpower planning, and so forth.
Forecasts and plans will probably be reviewed weekly.
Characteristics of Demand (Demand Patterns)
If historical data for demand is plotted against a time scale, it will show any shapes or consistent
patterns that exist.
A pattern is a general shape of the time series, and although some individual data points do not
fall on the pattern, they tend to cluster around it.
Actual demand typically varies from period to period. There are four reasons for this: trend,
seasonality, random variation and cycle.

Trend
A trend may be linear, but in other cases it may be of different shapes, such as geometric or
exponential.
The trend can also be level, having no change from period to period, or it can rise or fall.
Seasonality
Seasonal fluctuations may be the result of the weather, holiday seasons, or particular events that
take place on a seasonal basis.
While seasonality is usually thought of as occurring on a yearly basis, it can also occur on a
weekly or even daily basis. A restaurant's sales vary with the hour of the day, and supermarket
sales vary with the day of the week.
Random Variation
Many factors affect demand during specific periods and occur on a random basis.
The variation may be small, with actual demand falling close to the trend, or it may be large, with
the points widely scattered. The pattern of variation can usually be measured, and this will be
discussed in the section on tracking the forecast.
Cycle
Over a long time span of several years and even decades wavelike increases and decreases in the
economy influence demand.
Forecasting of cycles is beyond the scope of this Study Guide.
Stable versus Dynamic
The shape of the demand patterns for some products or services change over time while others do
not.
Those that retain the same general shape are called stable and those that do not are called dynamic.
Dynamic changes can affect the trend, seasonality, or randomness of the actual demand.
The more stable the demand, the easier it is to forecast.
Dependent vs Independent Demand
Demand for a product or service is independent when it is not related to the demand for any other
product or service.

Dependent demand for a product or service occurs where the demand for the item is derived from
that of a second item.
Requirements for dependent demand items need not be forecast but can be calculated from that of
the independent demand item.
Only independent demand items need be forecast. These are usually end items or finished goods.
Principles of Forecasting
Forecasts are usually wrong. Forecasts attempt to look into the unknown future and, except by
sheer luck, will be wrong to some degree. Errors are inevitable and one must live with them
Every Forecast should include an estimate of error. Since forecasts are expected to be wrong, the
real question is, "By how much?" Every forecast should include an estimate of error expressed as
a percentage (plus and minus) of the forecast or as a range between maximum and minimum
values. Estimates of this error can be made statistically by studying the variability of demand
about the average demand.
Forecasts are more accurate for families or groups. The behavior of individual items in a group is
random even when the group has very stable characteristics. For example, the marks for
individual students in a class are more difficult to forecast accurately than the class average. High
marks average out with low marks.
Forecasts are more accurate for nearer periods of time. The near future holds less uncertainty than
the far future . Most people are more confident in forecasting what they will be doing over the
next week than a year from now. As someone once said, tomorrow is expected to be pretty much
like today.
Principles of Collection and Preparation of Data
Record data in the same terms as needed for the forecast. This is a problem in determining the
purpose of the forecast and what is to be forecast. There are three dimensions to this:
If the purpose is to forecast demand on production, then data based on demand, not shipments, is
required. Shipments show what production was able to do in response to incoming orders. But if
demand exceeds capacity, shipments will not give a true indication of demand.
The forecast period, by weeks, months, or quarters for instance, should be the same as a schedule
period. If schedules are made up on a weekly basis, the forecast should be for the same time
interval.
The items forecast should be the same as those controlled by manufacturing. For example, if there
are a variety of options that can be supplied with a particular product, then the demand for the
product and for each option should be forecast.
Record the circumstances relating to the data.

Demand is influenced by particular events, and these should be recorded along with the demand
data.
For instance, artificial bumps in demand can be caused by sales promotions, price changes,
changes in the weather, or a strike at a competitor's factory.
It is vital that these factors be related to the demand history so they may be included or removed
for future conditions.
Record the demand separately for different customer groups.
Many firms distribute their Goods through different channels of distribution each having its own
demand characteristics.
A firm may sell to a number of wholesalers that order relatively small quantities regularly and sell
to a major retailer that buys a large lot twice a year.
Forecasts of average demand would be meaningless and each set of demands should be forecast
separately.
Forecasting Techniques
1. Qualitative
2. Causal
3. Quantitative
Qualitative Techniques
Projections based on judgment, intuition. and informed opinions.
By their nature, they are subjective.
Qualitative techniques are used to forecast general business trends and the potential demand for
large families of products over an extended period of time.
They are used mainly by senior management.
Production and inventory forecasting is usually concerned with the demand for particular end
items, and in most cases qualitative techniques are not appropriate.
When attempting to forecast the demand for a new product, there is no history on which to base a
forecast.
In these cases the techniques of market research and historical analogy might be used.

Market research is a systematic, formal, and conscious procedure for testing to determine
customer opinion or intention.
Historical analogy is based on a comparative analysis of the introduction and growth of similar
products in the hope that the new product behaves in a similar fashion.
The most frequently used Qualitative Technique is “The Delphi Method”.
Causal Techniques
Projections based on external indicators for which forecasts or actual data are available.
Examples of such data would be housing starts, birth rates, and disposable income.
The theory is that the sales of a product group are directly proportional or correlate to activity in
another field.
Examples of correlation are as follows:
Sales of bricks are proportional to housing starts.
Sales of automobile tires are proportional to gasoline consumption.
Economic Indicators
Housing starts and gasoline consumption are called economic indicators.
Economic Indicators describe economic conditions prevailing during a given time period.
Commonly used economic indicators:
 Construction contract awards

 Automobile production
 Farm income
 Steel production
 Gross National Product (GNP)
Data of this kind are compiled and published by various government departments, financial
papers and magazines, trade associations, and banks.
The problem is to find an indicator that correlates with sales and one that preferably leads sales,
that is, one that occurs before the sales do.
The number of construction contracts awarded in one period may determine the building material
sold in the next period.

When it is not possible to find a leading indicator, it may be possible to use a non-leading
indicator for which the government or an organization forecasts.
In a sense it is basing a forecast on a forecast.
Causal forecasting is most useful in forecasting the total demand for a firm's products or the
demand for families of products.
It is used most often in conjunction with business and production planning rather than the
forecasting of individual end items.
Quantitative Techniques
Quantitative forecasting techniques are based on the assumption that what happened in the past
will happen in the future.
Historical data is usually recorded in the company and is readily available.
The assumption that what happened in the past will happen in the future has been likened to
driving a car by looking out the rear-view mirror.
While there is some obvious truth to this, it is also true that in the absence of any other "crystal
ball," the best guide to the future is what has happened in the past.
Since quantitative techniques are so important, we will discuss some of the more important ones.
They are usually used as input to master production scheduling where end-item forecasts are
needed for the planning horizon of the plan.
Some Important Quantitative Techniques
Use of Simple Projections
You may assume sales this month will be the same as those last month:
This may appear too simple.
If there is little change in sales month to month, it probably will be quite accurate.
You might assume sales this month will be the same as sales the same month last year:
This rule is adequate if sales are seasonal.
It would be valid if there is little up or down trend.
Averages are Often Better

Rules such as these, based on a single month or period in the past, are of limited use when there is
much random fluctuation in demand.
Usually methods that average out history are better because they dampen out some of the effects
of random variation.
As an example, the average of last year's sales can be used as an estimate for January sales.
Such a simple average would not be responsive to trends or changes in level of sales. A better
method would be to use a moving average.
Moving Averages
One simple way to forecast is to take the average demand for, say, the last three or six periods and
use that figure as the forecast for the next period.
At the end of the next period the first-period demand is dropped and the latest period demand
added to determine a new average to be used as a forecast.
This forecast would then always be based on the average of the actual demand over the specified
period.
Moving Average Example
Suppose it was decided to use a 3-month moving average. Our forecast for January would take
the historical data for October, November, and December preceding and divide by three as
follows:
63 + 91 + 84 = 79
(O) (N) (D)
Now suppose that January sales turned out to be 90 instead of 79. The forecast for February
would be calculated as:
91 + 84 + 90 = 88
(N) (D) (J)
Notice how the forecast rises to reflect the higher recent values.
If a longer period, such as 6 months, is used, the forecast does not react as quickly.
The fewer months included in the moving average, the more weight is given to the latest
information, and the faster the forecast reacts to trends or seasonal variation.
However, the forecast will always lag behind a trend or seasonality.
Consider the following demand history for the past five periods:

Period Demand
1 1000
2 2000
3 3000
4 4000
5 5000
There is a rising trend to demand. If a five-period moving average is used, the forecast for period
six is (1000 + 2000 + 3000 + 4000 + 5000)/5 = 3000
Moving Average Example #2
This project does not look very accurate since the forecast is lagging actual demand by a great
amount.
However, if a 3-month moving average is used, the forecast is (3000 + 4000 + 5000)/3 = 4000
This is not perfect, but somewhat better.
The point is that a moving average always lags a trend and the more periods included in the
average, the greater the lag will be.
Moving Average Example #3
On the other hand, if there is no trend but actual demand fluctuates considerably due to random
variation, a moving average based on a small number of periods reacts to the fluctuation rather
than forecasts the trend. Consider the following demand history:
Period Demand
1 2000
2 5000
3 3000
4 1000
5 4000
The demand has no trend and is random.
If a 5-month moving average is used, the forecast for the next month is 3000--This reflects all the
values.
If a 2-month average is taken, the forecasts for the third, fourth, fifth, and sixth months are:
Forecast for 3rd month = (2000 + 5000)12 = 3500

Forecast for 4TH month = (5000 + 3000)/2 = 4000

Moving Average Major Points
Moving averages are best used for forecasting product with stable demand where there is little
trend or seasonality.
Moving averages are best used to filter out random fluctuations.
This has some common sense since periods of high demand are often followed by periods of low
demand.
One drawback to using moving averages is the need to retain several periods of history for each
item to be forecast.
This will require a great deal of computer storage or clerical effort.
In addition, the calculations are somewhat cumbersome.
A common forecasting technique that gives the same results as a moving average but without the
need to retain so much data and with easier calculations is called exponential smoothing.
Exponential Smoothing
It is not necessary to keep months of history to get a moving average because the previously
calculated forecast has already taken into account this history.
Therefore. the forecast can be based on the old calculated forecast and the new data.
Exponential smoothing assumes the most recent data should be given either more or less weight
than previous data.
The weight given to the latest actual data is called a smoothing constant and is represented by the
Greek letter alpha (a). It is always expressed as a decimal from 0 to 1.0.
Formula for Calculating a New Forecast
In general, the formula for calculating a new forecast is:
New forecast = (a)(latest Historical Data) + (1 - a)(previous forecast)
Exponential smoothing provides a routine method for regularly updating item forecasts.
It works quite well when dealing with fairly stable items.
Generally it has been found satisfactory for short-range forecasting.

It is not satisfactory where the demand is low or intermittent.
Exponential smoothing will detect trends although the forecast will lag actual demand if a
definite trend exists.
Double Exponential Smoothing
If a trend exists, it is possible to use a slightly more complex formula called double exponential
smoothing.
This technique uses the same principles but notes whether each successive value of the forecast is
moving up or down on a trend line.
Double exponential smoothing is beyond the scope of this Study Guide.
Selection of Best “Alpha” Factor
A problem exists in selecting the "best" alpha factor.
If a low factor such as 0.1 is used, the old forecast will be heavily weighted and changing trends
will not be picked up as quickly as might be desired.
If a larger factor such as 0.4 is used, the forecast will react sharply to changes in sales and will be
erratic if there is a sizable random fluctuation.
A good way to get the best alpha factor is to use computer simulation.
Seasonality
Many products have a seasonal demand pattern:
 Skis
 Lawnmowers
 Bathing suits
 Christmas tree lights
Less obvious are products whose sales vary by the time of day, week, or month:
Electric power usage during the day

Grocery shopping during the week
Power usage peaks between 4 and 7 p.m., and supermarkets are most busy toward the end of the
week.
Seasonal Index
A useful indication of the degree of seasonal variation for a product is the seasonal index.

This index is an estimate of how much the demand during the season will be above or below the
average demand for the product.
Swimsuit sales might average 100 per month, but in July the average is 175, and in September it
is 35 . The index for July sales would be 1.75 and for September sales 0.35.

The seasonal index can be based on daily, weekly, monthly, or quarterly sales. The formula is:
period average sales

Seasonal index = average sales for all periods
The period can be daily, weekly, monthly, or quarterly depending on the basis for the seasonality
of sales.
Seasonal Index Example
Suppose a product is seasonal based on quarterly sales and the sales for the past 3 years are given.
Assume no trend, with flat sales over the 3 years but assume definite seasonality.
Assume average quarterly sales of 100 units and average sales for quarter 1 of 128 units, for
quarter 2 of 102 units, and for quarter three of 75 units, and for quarter four of 95 units.
The seasonal indices can now be calculated as follows:
Seasonal index = 128 = 1.28 (quarter 1)

100
102 = 1.02 (quarter 2)

100
75 = 0.75 (QUARTER 3)
100
95 = 0.95 (QUARTER 4)
100
Total = 4.00
Note that the total of all the seasonal indices equals the number of periods. This is a good way to
check whether the calculations are correct.
Suppose that this company forecast sales for next year to be 420,000 units. How many units could
it expect to sell in each of the quarters?
Forecast quarterly sales = 420,000 = 105,000

4
Expected quarter sales = seasonal index X forecast quarterly sales
Expected first-quarter sales = 1.28 X 105,000 = 134,400 units
Expected second-quarter sales = 1.02 X 105,000 = 107,100 units

Expected third-quarter sales = 0.75 X 105,000 = 78,750 units
Expected fourth-quarter sales = 0.95 X 105,000 = 99,750 units
Deseasonalized Demand
Assume a company sells tennis rackets. Sales are usually best in the summer, but some people
play indoor tennis and there are sales in the winter months. If sales in January were 5200 units
and June sales were 24,000 units, how could January sales be compared to June sales to see
which was the better sales month? If there is seasonality, comparison of actual sales would be
meaningless. Deseasonalized data are needed to make a comparison. Deseasonalized data show
the average or base for sales:
actual demand
Deseasonalized demand = seasonal Index
If the seasonal indices based on history for June were 2.5 and for January 0.5, then:
Deseasonalized June demand = 24,000/2.5 = 9600
Deseasonalized January demand = 5200/0.5 = 10,400
June and January sales can now be compared.
On a deseasonalized basis January sales are greater than June sales.
Deseasonalized data must be used for forecasting.
Suppose that a smoothing constant of 0.1 was used and that the April and May seasonal indices
were 1.2 and 0.7, respectively. The previous deseasonalized forecast for April was 1000 and
actual sales in April were 1250.
To forecast May sales:
Deseasonalized April sales = 1250 = 1042

1.2
Deseasonalized forecast for May = 0.1(1042) + (0.9)1000 = 1004
Seasonal forecast for May = 1004(0.7) = 703
Rules for Seasonal Adjustment
 Keep the base forecast deseasonalized by using only deseasonalized data.
 Seasonalize the base forecast to predict actual demand for future periods.

Tracking the Forecast
Forecasts are usually wrong.
There are several reasons for this, some of which are related to human involvement and others to
the behavior of the economy.
We must make some determination as to the validity of our forecasts. We use this to improve
our forecasting methods and to re-plan around the error.
Continuing with a plan based on poor forecast data is not good.
Tracking the forecast is the process of comparing actual demand with the forecast.
Forecast Error
Defined as the difference between actual demand and forecast demand.
Error can occur in two ways:
 Bias
 Random Variation
Bias
Cumulative actual sales may not be the same as forecast.
Bias exists when the cumulative variance is not zero.
Bias is a systematic error where the actual demand is consistently above or below the forecast
demand.
When bias exists, the forecast can be changed to improve its accuracy.
The purpose of tracking the forecast is to be able to react to forecast error by planning around it or
trying to reduce it.
When unacceptably large error or bias is observed, it should be investigated to determine its cause.
Often there are exceptional one-time reasons for error:

 Machine breakdown
 Customer shutdown
 Large one-time orders
 Sales promotions

The above reasons relate to the discussion on collection and preparation of data and the need to
record the circumstances relating to the data.
In any event. the demand history must be adjusted to consider the exceptional circumstances.
Errors can also occur because of timing. (an early or late winter will affect the timing of sales of
snow shovels even though the cumulative sales will be the same).
Tracking cumulative demand will confirm liming errors or exceptional one-time events.
Random Variation
In a period (e.g., month), actual sales will vary plus and minus about the average sales.
The variability will depend upon the demand patter of the product.
Some products will have a stable demand and the variation will not be large.
Others will be unstable and will have a large variation.
Variation = actual - forecast
Mean Absolute Deviation (MAD)
Forecast error must first be measured before it can be used to revise the forecast or to help in
planning.
There are several ways to measure error, but one most commonly used is mean absolute deviation
(MAD).
Determined by calculating the total error ignoring the plus and minus signs and taking the average.
Mean implies an average,

Absolute means without reference to plus and minus, and
Deviation refers to the error.
MAD = sum of absolute deviations

number of observations
Normal Distribution
The mean absolute deviation measures the difference (error) between actual sales and forecast
Usually actual sales are close to the forecast but sometimes they are not.
If a plot is done of the number of times (frequency) actual sales are of a particular value, we get a
bell-shaped curve.

This distribution is called a normal distribution.
Normal Distribution Characteristics
The Central Tendency, or average (the forecast).
The Dispersion, or Spread, of the distribution (sometimes called the fatness or thinness of the
normal curve). This is measured by the Standard Deviation. The greater the dispersion, the
larger the standard deviation.
MAD as Measure of Dispersion
The Mean Absolute Deviation (MAD) is an approximation of the standard deviation.
From statistics we know that the error will be within + I MAD of the average about 60% of the
time, within +2 MAD of the average about 90% of the time, and within +3 MAD of the average
about 98% of the time.
MAD Uses
We can make some judgment about the reasonableness of the error. Under normal circumstances
the actual period sales will be within + 3 MAD of the average 98% of the time. If actual period
sales vary from the forecast by more than 3 MAD, we can be about 98% sure that the forecast is
in error.
The data can be used for contingency planning. Suppose a forecast is made that sales of door
slammers will be 100 units and that capacity for making them is 110 units. Mean absolute
deviation has been calculated at 10 units. This means there is a 60% chance that actual sales will
be between 90 and 110 units and a 40% chance that they will not.
Perhaps manufacturing management can devise a contingency plan to cope with the possible extra
sales.
The data can be used as a basis for setting safety stock.
Forecasting Handbook
The “Forecasting Handbook” (also available from ACI) contains many more forecasting
techniques specifically appropriate for purchasing. In that Handbook, much emphasis is
placed on the number 1 technique of quantitative analysis, which is Regression Analysis.

Collaborative Planning Forecasting and Replenishment
CPFR is not a technical standard. It is actually an initiative that facilitates the reengineering of the
relationships between trading partners and thus transactions. This initiative is based on an
industry-recognized set of standards which are not proprietary. ―True collaboration is something
that completely reengineers the relationship or the transaction between trading partners,‖ notes
Andrew White, vice president of product strategy for Logility, an Atlanta-based company that
offers a CPFR-based supply chain management application.
Although the Internet has enabled more self-service and faster service, as in the examples of
Dell.com and Amazon.com, up to this point transaction methods have not really changed much.
This kind of collaboration is all about doing things differently.
CPFR provides templates for supply chain partner collaboration. The process model at below is
segmented into three stages. The planning stage establishes and updates the relationship; the sales
forecasting and order replenishment stages occur more frequently.
CPFR Process Model
CPFR processes depend on the comparison of data: comparing one organization‘s plans with
another; comparing a new version of one organization‘s plans with a previous plan; or comparing
a plan to actual results. In other words, CPFR manages by exception—it addresses variances,
whether plan-to-plan or plan-to-actual.
An important premise of this model is that accuracies in the forecast can be improved by having
the customer and supplier participate in the forecast. A retailer can compare its demand or sales
forecast with the manufacturer‘s order forecast. If a discrepancy occurs,
the two trading partners can react—they can get together and decide on the replenishment
quantity to recify any such discrepancies. Hence, a supplier can build inventory well in advance
of receiving a promotional order, and carry less safety stock at other times. A customer can alter
the product mix to reduce the impact of supply problems.
CPFR creates a win–win scenario, tying the buyer and seller together so that their goals are
compatible. By competing as one, the buyer and seller form a value chain that will come out
ahead of other buyers and sellers who are still caught up in price negotiations.

CPFR Has Evolved from a Heritage of Supply Chain Solutions
CPFR is considered to be the next stage in the evolution of supply chain initiatives.
Older supply chain operations had gaps in their practices, including financial plans taking
precedence over forecasts and non-integrated supply planning. This resulted in higher inventory
levels, lower order fill rates, and increased expedited activity. Companies were not realizing the
benefits that they expected.
Only later did companies start focusing on process integration—managing the supply chain from
raw materials through delivery to the end user. The difference between CPFR and other business
process tools, such as Efficient Consumer Response, is that the other models require critical mass
before any benefits are realized. With CPFR, a customer can improve performance by just having
a collaborative relationship with one vendor.
The story began in 1995 when retailer Wal-Mart found that consumer products and
pharmaceutical company Warner-Lambert‘s in-stock averages were not up to par with Wal-
Mart‘s vendor performance standards. Wal-Mart, along with Warner-Lambert,
Surgency, (formerly Benchmarking Partners), and two software companies, SAP and Manugistics,
spearheaded an effort to define a process that would link customer demand with replenishment
needs through the entire supply chain.
The pilot focused on stock of Listerine mouthwash kept in stores. The group actually first tested
the collaborative concept on paper, and then demonstrated in a computer lab that the Internet
could be used for the information exchange. Here‘s what happened: Warner-Lambert‘s in-stock
averages rose from 87% to 98%. Lead times dropped from 21 to 11 days. And sales increased
$8.5 million over the test period—even though the pilot was limited to one Warner-Lambert
manufacturing plant and three Wal-Mart distribution centers.
Summary
Forecasts should be tracked.
There should be a measure of reasonableness of error.
When actual exceeds the reasonableness of error, an investigation should be made to discover the
cause of the error.
If there is no apparent cause of error, then the method of forecasting should be reviewed to see if
there is a better way to forecast.
Inventory Fundamentals

Inventories are those materials and supplies carried on hand by a business or institution either for
sale or to provide inputs or supplies to the production process.
All businesses and institutions require inventories.
The British refer to inventory as ―Stock‖.
Inventories are often a substantial part of total assets and are carried on the Balance Sheet of the
firm.
Financially, inventories are very important to manufacturing companies (On the Balance Sheet
they usually represent from 20 to 60% of total assets.
When inventories are reduced, their value is converted into cash, which improves cash flow and
return on investment.
There is a cost to carrying inventories, which increases operating costs and decreases profits of
the company.
Good inventory management is essential.
Inventory management in a firm is responsible for planning and controlling inventory from the
raw material stage to the customer.
Since inventory either results from production or supports it, it is often not possible to manage the
two separately. As a minimum, they must be coordinated.
Inventories must he considered at each of the planning levels and are thus part of production
planning, master production scheduling, and material requirements planning.
Production planning is concerned with overall inventory, master planning with end items, and
material requirements planning with component parts and raw material.
At the production planning level inventory management deals with total inventory.
This is called aggregate inventory management.
The concern here is managing inventories according to their classification:
1. Raw Material
2. Work in Process
3. Finished Goods
Aggregate inventory management is also concerned with function inventories perform rather than
at the individual item level.
Aggregate Inventory Management

Financially oriented and concerned with the costs and benefits of carrying the different
classifications of inventories.
Aggregate inventory management is involved with:
 The flow of materials and the kinds of inventory needed

 Supply and demand patterns
 The functions inventories perform
 The objectives of inventory management
 The costs associated with inventories
Item Level Inventory Management
Inventory must not only be managed at the aggregate level but also at the item level.
To do so, management must establish decision rules about inventory items so the staff responsible
for inventory control can do its job effectively.
Inventory Management Decision Rules
1. Deciding on the importance of individual inventory items and how they are to be controlled.
2. How much to order at one time.
3. When to place an order.
Inventory Classifications
The classification system used often is related to the flow of materials into, through, and out of a
manufacturing organization.
Raw Materials. These are purchased items that have been received but have not entered the
production process. They include purchased materials. component parts and subassemblies.
Work In Process (WIP). Raw materials that have entered the manufacturing process and are being
worked on or are waiting to be worked on.
Finished Goods. The finished products of the production process that are ready to be sold as
completed items. They may be held at a factory or central warehouse or at various points in the
distribution system.
Distribution Inventories. Finished goods that are located in the distribution system
Maintenance, Repair and Operating (MRO Supplies. Items that are used in production but do
not become part of the product. These include hand tools, spare parts, lubricants cleaning supplies,
and so on.

Classification Varies
Classification of an item into a particular inventory depends on the production environment.
Sheet steel or tires are finished goods to the .supplier but are raw materials and component parts
to the car manufacturer.
Supply and Demand Patterns
If supply were able to meet demand exactly there would be little need for inventory.
Goods could be made at the same rate as demand and no inventory need be built up.
For this situation to exist demand must be predictable, stable, and relatively constant over a long
time period.
If this is so then manufacturing can produce goods on a line flow basis matching production to
demand.
Raw materials can be fed to production as required work flow from one work station to another
can be balanced so little work-in-process inventory is required and goods can be delivered to the
customer at the rate the customer needs them.
Because line flow systems are so limited in the variety of products they can make demand has to
be large enough to economically justify setting up the system.
Line Flow Systems
Characteristic of just-in-time manufacturing (JIT).
JIT is discussed later.
“Normal Demand Flow”
The demand for most products is not sufficient or constant enough to warrant setting up a line
flow system and these products are usually made in lots or batches.
Work stations are organized by function.
All machine tools in one area all welding in another and assembly in another.
Work moves in lots from one work station to another as required by the routing.
By the nature of the system, inventory will build up in raw materials work in process and finished
goods.
Function of Inventory in Batch/Lot Manufacturing

In batch or lot manufacturing the basic purpose of inventories is to decouple supply and demand.
The purpose of inventories is thus to serve as a buffer:
 Between customer demand and finished goods.
 Between finished goods and component availability.
 Between requirements for an operation and the output from the preceding operation.
 Between parts and materials to begin production and the suppliers of materials.
Classification of Inventories According to Function
 Anticipation Inventory
 Fluctuation Inventory
 Lot Size Inventory
 Transportation Inventory
 Hedge Inventory
Anticipation Inventory
These inventories are built up in advance of a peak selling season, A promotion program,
vacation shutdown, or possibly the threat of a strike.
They are built up to help level production and to reduce the costs of changing production rates.
Fluctuation Inventory
Inventory is held to cover random, unpredictable fluctuations in supply and demand or lead time.
If demand or lead time is greater than Forecast, then a stock out will occur.
Safety stock is carried to protect against the possibility of a stock out.
Its purpose is to prevent disruptions in manufacturing or deliveries to customers.
Lot Size Inventory
Items that are purchased or manufactured in quantities greater than needed immediately create lot
size inventories.
Items will be ordered in lots or batches to get quantity discounts to reduce shipping, clerical, and
setup costs, and in cases where it is impossible to make or purchase items at the same rate they
will be used or sold.
Transportation Inventory

These inventories exist because of the time required to move stock from one location to another.
They are sometimes referred to as pipeline or movement inventories.
The only way to reduce the inventory in transit, and its cost, is to reduce the transit time.
Hedge Inventory
Some products such as minerals and commodities (e.g., grains or animal products) are traded on a
worldwide market.
The price for these products fluctuates according to world supply and demand.
If buyers expect that prices will rise. they can purchase hedge inventory when prices are low.
The buying of these inventories is complex and beyond the scope of this Study Guide.
Objectives of Inventory Management
 Maximum customer service
 Low-cost plant operation
 Minimum inventory investment
Customer Service
The term Customer Service is used to describe the availability of items when needed and is a
measure of inventory management performance.
The customer can be a purchaser, a distributor, another plant in the organization, or the work
station where the next operation is to be performed.
Management of Customer Service
There are many different ways to measure customer service, each with their strengths and
weaknesses, but there is no one best measurement.
 Percentage of orders shipped on schedule.
 Percentage of line items shipped on schedule.
 Order-days out of stock.
 Minimization of Uncertainty

Inventories help to maximize customer service by protecting against uncertainty.
If we could forecast exactly what customers want and when, we could plan to meet demand with
no uncertainty.
However, actual demand is uncertain and, as well, the lead time to get an item is often uncertain.
These can result in stockouts and customer dissatisfaction.
It may be necessary to carry extra inventory to protect against uncertainty.
Operating Efficiency
Inventories can help make a manufacturing operation more productive in four ways:
Inventories allow operations with different rates of production to be operated separately and thus
more economically
Level production and build anticipation inventory for sale in the peak periods, resulting in kower
overtime costs; lower hiring and firing costs; lower training costs; lower subcontracting costs;
lower capacity required; and operating efficiency.
Inventories allow longer production runs, which result in lower setup costs per item and an
increase in production capacity due to production resources being used a greater portion of the
time for processing as opposed to setup.
Inventories allow manufacturing to purchase in larger quantities which results in lower ordering
costs per unit and quantity discounts.
Balance Needed Between Inventory Investment and Other Factors
Customer Service. The lower the inventory the higher the likelihood of a stockouts and the
lower the level of customer Service. (The higher the inventory level, the higher Customer
Service will be).
Costs Associated With Changing Production Levels. Excess equipment capacity, overtime,
hiring, training, and layoff costs will be higher if production must fluctuate with demand.
Costs of Placing Orders. Lower inventories can be achieved by ordering less more often, but this
practice results in higher annual ordering costs.
Transportation Costs. Goods moved in small quantities cost more to move per unit than those
moved in large quantities. However, moving large lots of goods implies higher inventory.
If inventory is carried. there has to be a benefit that exceeds the costs of carrying that inventory.

Inventory Costs
 Item Cost
 Carrying Costs
 Ordering Costs
 Stock out Costs
 Capacity-Related Costs
Item Cost
The price paid for a purchased item is the cost of the item and any other direct costs associated in
getting the item into the plant.
These could include such things as transportation, custom duties, and insurance.
The all inclusive cost is often referred to as the (total) landed cost (TLC).
For an item manufactured in house the cost includes direct material, direct labor, and factory
overhead.
These costs can usually be obtained from either purchasing or accounting.
Carrying Costs
Include all expenses incurred by the firm because of the volume of inventory carried.
As inventory increases, so do these costs.
Three Categories of Carrying Costs
Capital Costs
Money invested in inventory is not available for other uses and as such represents a lost
opportunity cost.
The minimum cost would be the interest lost by not investing the money at the prevailing interest
rate and may be much higher depending on the investment opportunities of the firm.
Storage Costs
Storing inventory requires space, manpower and equipment.
As inventory increases, so do these costs.

Risk Costs (Examples)
Obsolescence. loss of product value resulting from a model or style change or technological
development
Damage, inventory damaged while being held or moved.
Pilferage. goods lost, strayed, or stolen.
Deterioration. inventory that rots or dissipates in storage or whose shelf life is limited.
What Does it Cost to Carry Inventory?
Actual figures vary from industry to industry and company to company.
Capital costs can vary depending upon interest rates; the credit rating of the firm; and the
opportunities the firm may have for investment.
Storage costs vary with location and type of storage needed.
Risk costs can be very low or can be close to 100% of the value of the item for perishable goods.
The carrying cost is usually defined as a percentage of the dollar value of inventory per unit of
time (usually 1 year).
Textbooks tend to use a figure of 20-30% in manufacturing industries--This is realistic in many

cases but not with all products.
Possibility of obsolescence with fad or fashion items is high and the costs of carrying such items
are greater.
Ordering Costs
These are costs associated with the placing of an order either with the factory or a supplier.
The cost of placing an order does not depend upon the quantity ordered.
Whether a lot of 10 or 100 is ordered, the costs associated with placing the order are essentially
the same.
The annual cost of ordering depends upon the number of orders placed in a year.
Factory Ordering Costs
Production Control Costs

The annual cost and effort expended in production control depends on the number of orders
placed, not on the quantity ordered.
The fewer orders per year, the less cost.
The costs involved are those of issuing and closing orders, scheduling, loading, dispatching, and
expediting.
Setup and Teardown Costs
Every time an order is issued, work centers are involved in setting up to run the order and tearing
down the setup at the end of the run.
These costs do not depend upon the quantity ordered; rather the annual cost depends upon the
number of orders placed per year.
Lost Capacity Costs
Every time an order is placed at a work center, the time taken to set up is lost as productive output
time.
This represents a loss of capacity and is directly related to the number of orders placed.
It is particularly important and costly with bottleneck work centers.
Purchase Order Costs
Every time a purchase order is placed, costs are incurred to place the order. These costs include:
 Order preparation
 Follow-up
 Expediting
 Receiving
 Authorizing payment
 The accounting cost of receiving and paying the invoice.
Annual cost of ordering depends upon the number of orders placed In a year.
This can be reduced by ordering more at one time, resulting in the placing of fewer orders.
However, this drives up the inventory level and the annual cost of carrying inventory.
Stock out Costs
If demand during the lead time exceeds forecast, then we can expect a stock out.
Potentially a stock out can be expensive because of back-order costs, lost sales, and possible lost
customers.

Stockouts can be reduced by carrying extra inventory to protect against those times when the
demand during lead time is greater than forecast.
Capacity-Associated Costs
When output levels must be changed, costs can be incurred for overtime, hiring, training, extra
shifts, and layoff.
These costs can be avoided by leveling production by producing items in slack periods for sale in
peak periods.
Summary
There are benefits as well as costs to having inventory.
The problem is to balance the cost of carrying inventory with the following:
Customer Service. The lower the inventory level, the higher the likelihood of a stock out and the
potential cost of back orders, lost sales, and lost customers. The higher the inventory level, the
higher the level of customer service.
Costs Associated With Changing Production Levels. Excess equipment capacity, overtime. hiring,
training, and layoff costs are all higher if production fluctuates in response to changes in demand.
Transportation and Handling Costs. The more often goods have to he moved and the smaller the
quantities moved, the greater the transportation and material handling costs.
Inventory management is influenced by a number of factors:
Classification of inventory, whether raw material, work in process, or finished goods.
Function the inventory serves (anticipation, fluctuation, lot size, or transportation).
The supply and demand patterns.
In addition to managing inventory at the aggregate level, it must also be managed at the item level.
Management needs to establish decision rules about inventory items so the inventory control staff
can do their job effectively.

ABC Inventory Management
A system that can be used to decide the importance of items, and therefore the type of control
needed, is the ABC inventory classification.
Most companies carry a tremendous number of items in stock.
To have better control of these items at a reasonable cost, it is helpful to be able to classify them
according to their importance.
Usually this is based upon the annual dollar volume, but other criteria may be used.
The ABC principle is based on the observation that relatively few items often dominate the
results achieved in any situation.
This observation was first made by an Italian economist, Vilfredo Pareto, and is sometimes
referred to as Pareto's law or rule.
As applied to inventories, it is usually found that the relationship between the percentage of items
and the percentage of annual dollar usage follows a pattern:
About 20% of the items account for about 80% of the dollar usage
About 30% of the items account For about 15% of the dollar usage
About 50% of the items account for about 5% of the dollar usage
The percentages are approximate and should not be taken as absolute. This type of distribution
can be used to help control inventories.
Steps in ABC Management
Establish the item characteristics that influence the results of inventory management,
Classify each item into groups based on the criteria established.
Apply a degree of control in proportion to the importance of the group.
(The Factors that affect the importance of the item include annual dollar usage, unit cost, and
scarcity of material. For simplicity only annual dollar usage is used here.)

ABC Development Procedure
1. Determine the annual usage for each item in the group.
2. Multiply the annual usage of each item by its cost to obtain its total annual dollar usage.
3. List the items according to their annual dollar usage.
4. Calculate the cumulative annual dollar usage and the cumulative percentage of items.
5. Examine the annual usage distribution and group the items into A, B, and C groups on the
basis of percentage of annual usage.
Inventory Management/Control Based on ABC Classification
Using the ABC approach, there are two general rules to follow:
1. Have plenty of low-value items.
2. Use the money and control effort saved to reduce the inventory of high-value items.
Different Controls Used With Different Classifications
"A" Items (high priority): Tight control, including complete accurate records, regular and frequent
review by management, frequent review of demand forecasts, and close follow-up and expediting
to reduce lead time. Perhaps use a perpetual inventory system.
"B" Items (medium priority): Normal controls involving good records, regular attention, and
normal processing.
"C" Items (lowest priority): Simplest possible controls—make sure there are plenty; simple or
no records; perhaps use a two-bin system or periodic inventory review system. Order large
quantities and carry safety stock.
Order Quantities
The objective of inventory management is to provide the required level of customer service.
To do so, two basic questions must be answered:
How much should be ordered at one time?
When should an order be placed?

Decision Rules Needed
Management must establish decision rules to answer these questions so those working in
inventory management know when to order and how much.
In the absence of any better knowledge, decision rules are often made on the basis of what seems
reasonable.
Unfortunately, such rules do not always produce the best results.
We will attempt to answer these two questions in turn.
Inventory Control
Control is exercised through individual items in a particular inventory.
These are referred to as stock-keeping units (SKU).
Two white shirts in the same inventory but of different sizes or styles would be two different
SKUs.
The same shirt in two different inventories would be two different SKUs.
Techniques in Determining How Much to Order
 Lot-For-Lot ordering rules
 Fixed-order quantity rules
Lot-For-Lot Ordering Decision Rules
Order the exact requirement for an item in each time period.
The order quantity changes whenever requirements change.
Requires time-phased information such as that provided by a material requirements plan or a

master production schedule.
Since items are ordered only when needed, this system creates no unused lot size inventory.
It is the best method for planning "A" inventory items.

Fixed-order Quantity Lot Size Decision Rules
Specify the number of units to be ordered each time an order is placed for an individual item or
SKU.
The quantity may be arbitrary, such as 200 units at a time, but is often based on an Economic
Order Quantity (EOQ).
Determining how much to order at one time depends on the costs that will be affected by the
quantity ordered.
Ideally the ordering decision rules that are established minimize the sum of all these costs.
Economic Order Quantity (EOQ)
At the heart of the EOQ principle are two key variable costs of inventory management: the "how
much to order," and the "how often to order" (frequency of orders). EOQ is based on the
following principles:
1. The range and depth of an inventory can be controlled by using statistical concepts to
determine the size and frequency of replenishment orders over a given period of time;
2. Determining "how often to order" is based upon the quantity of stock required to last through
an average order and shipping interval without "running out" of stock or exhausting the safety
level;
3. The "how much to order" element is a separate problem from the "how often to order" element
of the problem. It is based upon a formula designed to obtain the optimum order quantity that
will result in the lowest sum of ordering and carrying/holding costs;
4. The application of these principles to selected segments of the inventory enables the supply or
inventory manager to predict the trends in inventories and to manage supply effectiveness in
terms of cost; and
5. The relationship between ordering and carrying/holding costs can be balanced to determine the
most economical quantities to be ordered and held.
Economic Order Quantity (EOQ) is determined by finding that point where ordering and carrying
costs are equal. At this point, total cost is the lowest (see graph below).

Economic Order Quantity
Ordering and Carrying Costs
(Thousands)
12
11
10
9
Orde ri ng and Ca rryi ng
(T ho us ands )
C os ts
Ec o no mic Ord er Quantity
12
11
8 10
9
8
7 Total Cost
Total Cos t
6
Carryi ng Cos t
5
7 4
3
2
1
Orde ri ng Cos t
0
0 200 400
6 Orde r Q uanti ty
Carrying Cost
5
4
3
Ordering Cost
2
1
0
0 200 400
Order Quantity
Independent Demand Ordering Systems
The Economic Order Quantity addressed the question of how much to order at one time.
Another important question is when to place a replacement order.
If stock is not reordered soon enough there will be a stockout and a potential loss in customer
service.
But if stock is ordered earlier than needed there will be extra inventory carried.
The problem then is how to balance the costs of carrying extra inventory against the costs of a
stock out.

No matter what the items are, some rules are needed to tell when to reorder.
They can be simple rules such as order when needed order every month or order when stock falls
to a predetermined level.
We all use rules of some sort in our own lives and they vary depending on the importance placed
on the item.
A homemaker uses some intuitive rules to make up the weekly shopping list.
"Order enough meat for a week; order salt when the box is empty; order vanilla extract if it will
be needed over the next week; and so on.
In industry there are many inventories that involve a large investment and where stockout costs
are high.
In order to control these inventories, effective reorder systems are needed.
Systems Used to Determine When to Order
1. Order Point System
2. Periodic Review System
3. Material Requirements Planning (MRP)
(The first two are for independent demand items and the last is for dependent demand items)
Order Point System
When the quantity on hand of an item in inventory falls to a predetermined level called an order
point, an order is placed.
The quantity ordered is usually pre-calculated and based on economic order quantity concepts.
Using this system, an order must be placed when there is enough stock on hand to satisfy demand
from the time the order is placed until the new stock arrives (called the lead time).
Suppose that for a particular item the average demand is 100 units a week and the lead time is 4
weeks.
If an order is placed when there are 400 units on hand, on the average there will be enough stock
on hand to last until the new stock arrives.
However, demand during any one lead time period probably varies from the average—sometimes
more and sometimes less than the 400.

Statistically the demand is greater than average half the time and there is a stock out, and the
demand is less half the time and there is extra stock.
If it is necessary to provide some protection against a stock out, safety stock can be added.
The item would then be ordered when the quantity on hand falls to a level equal to the demand
during the lead time plus the safety stock: OP = DDLT + SS.
where
OP = order point
DDLT = demand during the Lead time
SS = safety stock
It is important to note that it is the demand during the lead time that is important.
If the lead time is reduced to zero, no safety stock is needed, but as the lead time is increased,
more safety stock is required to give the same level of protection against a stock out.
Principles of Order Point System
Order quantities are usually fixed.
The order point is determined by the average demand during the lead time. If the average demand
or the lead time changes and there is no corresponding change in the order point, then effectively
there has been a change in safety stock.
The intervals between replenishments are not constant but vary depending on the actual demand
during the reorder cycle.
Average inventory = Order Quantity/2 + safety stock.
Determining the order point depends on the demand during the lead time and the safety stock
required.
Methods of estimating the demand during the lead time were discussed previously.
We now look at the problem of determining safety stock.
Determining Safety Stock
The safety stock required depends on the following:
 Variability of demand during the lead time

 Frequency of reorder
 Service Level desired

 Length of the lead time. The longer the Lead time the more safety stock has to be carried to
provide a given service Level. This is why it is important to reduce it at times as much as
possible.
 Ability to forecast or control lead times. With some products lead times can vary
considerably and are difficult to control

Variation in Demand During Lead Time
Actual demand varies from forecast for two reasons:
Bias error in forecasting the average demand.
Random variations in demand about the average.
It is the latter that we are concerned with in determining safety stock.
Variation in Demand About the Average-Normal Distribution
Everything in life varies, even identical twins to some extent.
The pattern of demand distribution about the average will be different for different products and
markets.
What is needed is some method of describing the distribution--its shape, center, and spread.
Most demand patterns are stable and predictable.
The most common predictable pattern is called a normal curve, or bell curve, because its shape
resembles a bell.
The normal distribution has most of the values clustered near a central point with progressively
fewer results occurring away from the center.
It is symmetrical about this central point in that it spreads out evenly on both sides.
The normal curve is described by two characteristics. One relates to its central tendency, or
average, and the other to the variation, or dispersion of the actual values about the average.
Average or Mean
This value is at the high point of the curve
It is the central tendency of the distribution
The symbol for the mean is x (pronounced "x bar"). It is calculated by adding the data and
dividing by the total number of data
The Variation, or Dispersion
Can be measured in a number of ways:
 As a range of the maximum minus the minimum value

 As a standard deviation. This is a statistical value that measures how closely the individual
values cluster about the average
 As the mean absolute deviation (MAD), which is a measure of the average forecast error

Mean Absolute Deviation (MAD)
MAD = sum of absolute deviations

number of observations
It is important to note that these deviations in demand are for the same time interval as the lead
time.
If the lead time is 1 week, then it is the variation in demand over a 1 -week period that is needed
to determine safety stock.
Statistics Lessons Learned
The actual demand will be within + or - 1 MAD of the forecast average about 60% of the
time.
Time.
Time.
Determining the Safety Stock and Order Point
Now that we have calculated the Mean Absolute Deviation we must determine how much safety
stock is needed.
One of the properties of the normal curve is that it is symmetrical about the average.
This means that half the time the actual demand is less than the average and half the time it is
greater.
Safety stocks are needed to cover only those periods when the demand during the lead time is
greater than the average.
Thus a service level of 50%% can be achieved with no safety stock.
If a higher service level is needed then safety stock must be provided to protect against those
times when the actual demand is greater than the average.
We know from statistics that the error is within + or - 1 MAD of the forecast about 60% of the
time (30% of the time less and 30% of the time greater than the forecasts.
Suppose the Mean Absolute Deviation of demand during the lead time is 100 units and this
amount is carried as safety stock.

This much safety stock provides protection against stock out for the 30% of the time the actual
demand is greater than expected.
In total there is enough safety stock to provide protection for 50 + 30 = 80% of the time a stock
out is possible.
The service level is a statement of the percentage of the time there is no stock out.
But what exactly is meant by supplying the customer 80% of the time?
It means being able to supply when a stock out is possible and a stock out is possible only at the
time an order is to be placed.
If we order 100 times a year. there are 100 chances of a stock out.
With safety stock equivalent to one mean absolute deviation we would expect, on the average, no
stockouts about 80 of the 100 times.
Safety Stock & Order Point-Example
Assuming a MAD of 160 units, we can calculate the safety stock and the order point for an 80%
service level:
Safety Stock = 1 MAD

= 1 x 160
= 160 units
Order point = DDLT + SS = 1000 + 160 = 1160 units
Assuming a MAD of 160 units, we can calculate the safety stock and the order point for an 95%
Service level:
Safety Stock = 2 MAD

= 2 x 160
= 320 units
Order point = DDLT + SS = 1000 + 320 = 1320 units
Safety Factor
The service level is directly related to the number of mean absolute deviations provided as safety
stock and is usually referred to as the safety factor
Service Level Safety Factor

50 0.00
75 0.84
80 1.05

85 1.30
90 1.60
94 1.95
95 2.06
96 2.19
97 2.35
98 2.56
99 2.91
99.5 3.20
99.99 5.00
Safety Factor-Example
Assume MAD is 200 units, service level is 90%, expected demand during lead time is 1500 units,
what is the order point?
SS = MAD X safety factor = 200 X 1.60 = 320
OP = DDLT + SS = 1500 + 320 = 1820 Units
Determining Service Levels
Theoretically we want to carry enough safety stock on hand so the cost of carrying the extra
inventory plus the cost of stockouts is a minimum.
Stockouts cost money for the following reasons:
 Back-order costs
 Lost sales
 Lost customers
The cost of a stock out varies depending on the item, the market served, the customer, and
competition.
Customer service is a major competitive tool, and a stock out can be very expensive.
In some industries, it may not be a major consideration.
Stock out costs are difficult to determine.
Usually the decision as to what the service level should be is a senior management decision and is
part of the company's corporate and marketing strategy.
The only time it is possible for a stock out to occur is when stock is running low, and this
happens every time an order is to be placed.
The chances of a stock out are directly proportional to the frequency of reorder.

The more often in a year that stock is reordered, the more often there is a chance of a stock out.
When the order quantity is increased, exposure to stock out decreases.
The safety stock needed decreases, but because of the larger order quantity, the average inventory
increases.
What is needed is a statement from management as to the number of stockouts per year that are
tolerable.
With this, the service level, safety stock, and order point can be calculated
Different Forecast and Lead Time Intervals
There are usually many items in an inventory each with different lead times.
Normally we expect that records of actual demand and forecasts are made on a weekly or monthly
basis for all items regardless of what the individual lead times are.
It is almost impossible to measure the variation in demand about the average for each of the lead
times.
Some method of adjusting mean absolute deviation for the different time interval is needed.
If the lead time is zero, the mean absolute deviation of demand is zero, and as the lead time
interval increases, the mean absolute deviation increases.
However, it will not increase in direct proportion to the increase in time.
For example, if the mean absolute deviation is 100 for a lead time of 1 week, then for a lead time
of 4 weeks it will not be 400 since it is very unlikely that the deviation would be high for 4 weeks
in a row.
As the time interval increases. there is a smoothing effect, and the longer the time interval, the
more smoothing takes place.
The following adjustment can be made to the mean absolute deviation or the safety stock to
compensate for differences between lead time interval (LTI) and forecast interval (FI). While not
exact, the formula gives a good approximation:
MAD for LTI = MAD for Fi X square root LTI/FI
Example
Suppose the forecast interval is 4 weeks, the lead time interval is 2 weeks, and MAD For the
forecast interval is 150 units. Then:

MAD for LTI = 150 X square root of 2/4 = 150 X .0.707 = 106
The preceding relationship is also useful where there is a change in the LTI.
In this case it is probably more convenient to work directly with the safety stock rather than the
mean absolute deviation.
New Example
Suppose the safety stock for an item is 150 units and the lead time 2 weeks.
If the lead time changes to 3 weeks, the new safety stock is calculated using the preceding
relationship with slight modification:
SS (NEW) = SS (OLD) X square root (New Lead Time/Old Lead Time)
SS (new) = 150 X square root 3/2 = 150 X 1.22 = 183 units
Determining When the Order Point is Reached
There must be some method to show when the quantity of an item on hand has reached the order
point.
In practice, there are a great many systems.
They all are inclined to be variations or extensions of two basic systems: the two-bin system and
the perpetual inventory system.
Two-Bin System
A quantity of an item equal to the order point quantity is set aside (Frequently in a separate or
second bin) and not touched until all of the main stock is used up.
When this stock is broken into, the production control or purchasing department is notified and a
replenishment order is placed.
There are variations on this system, such as the red tag system, where a tag is placed in the stock
at a point equal to the order point.
Book stores frequently use this system. A tag or card is placed in a book that is in a stack in a
position equivalent to the order point. When a customer takes that book to the checkout, the
store is effectively notified that it is time to reorder that title.
Two-Bin if often used for ―C‖ inventory items.
Perpetual Inventory Record System

A continual account of inventory transactions as they occur.
At any instant it contains an up--to-date record of transactions--At a minimum it contains the

balance on hand.
It may also contain the quantity on order but not received, the quantity allocated but not issued,
and the available balance.
The accuracy of the record depends upon the speed with which transactions are recorded as well
as the accuracy of the input.
Because manual systems rely on the input of human beings, they are more likely to have slow
response and inaccuracies caused by human error.
Computer-based systems have a higher transaction speed and reduce the possibility of human
error.
These systems are often used for ―A‖ inventory items.
Inventory Records for a Perpetual Inventory System
Permanent Information typically includes part number, name, and description, storage location,
order point, order quantity, lead time, safety stock, and suppliers.
Variable information is information that changes with each transaction and typically includes
quantities ordered (dates, order numbers, and quantities), quantities received (dates, order
numbers, and quantities), quantities issued (dates, order numbers, and quantities), balance on
hand, allocated (dates, order numbers, and quantities), and available balance.
The information depends on the needs of the company and the particular situation.
Inventory Accuracy
The usefulness of the perpetual inventory record is directly related to its accuracy.
On the basis of the inventory record, a company determines net requirements for an item, releases
orders on the basis of material availability, and performs inventory analysis.
If the records are not accurate, there will be shortages of material, disrupted schedules, late
deliveries, lost sales, low productivity, and excess inventory (of the wrong things).
If inventory records are to be accurate, the movement of the goods must be processed properly.
There must be a good record-keeping system, the storeroom must be secure so no unauthorized
withdrawals can be made, and there should be a good method of auditing inventory transactions
and record accuracy.

Auditing Inventory Records
There are two basic methods of checking the accuracy of inventory records.
1. Periodic (usually annual) counts of all items.

2. Cyclic (usually daily) counts of specified items.
It is important to audit record accuracy, but it is more important to audit the system to find the
causes of record inaccuracy and eliminate them. Cycle counting does this; periodic audits tend not
to
Cycle Counting
A system of counting inventory continually throughout the year.
The idea is to count selected items each day.
Depending on their importance, some items are counted frequently throughout the year while
others are not.
The number of times an item is counted in a year is referred to as its count frequency.
Ideally the frequency increases as the number of transactions increases (more chance of error) and
as the value of the item increases.
There are a number of systems used to select items; one of the more popular is the ABC method.
Inventories are classified according to the ABC system--Some rule is then established for count
frequency.
A items might be counted weekly or monthly, B items bimonthly or quarterly, and C items
biannually or once a year.
On this basis a count schedule can be established.
Periodic Review System
In the order point system an order is placed when the quantity on hand falls to a predetermined
level called the order point.
The quantity ordered is usually predetermined on some basis such as the economic order quantity.
The interval between orders varies depending on the demand during any particular cycle.
Using the periodic review system, the quantity on hand of a particular item is determined at
specified, fixed time intervals and an order is placed.

The review period is fixed and the order quantity is allowed to vary.
The quantity on hand plus the quantity ordered must be sufficient to last until the next shipment is
received.
The quantity on hand plus the quantity ordered must equal the sum of the demand during the lead
time plus the demand during the review period plus the safety stock.

Target Level or Maximum-Level Inventory
The quantity equal to the demand during the lead time plus the demand during the review period
plus safety stock is called the target level or maximum-level inventory.
The order quantity is equal to the maximum inventory level minus the quantity on hand at the
review period.
Periodic Review System Useful
If there are many small issues from inventory, and posting transactions to inventory records are
very expensive (supermarkets and retailers).
If ordering costs are small--This occurs when many different items are ordered from one source
(A regional distribution center may order its stock from a central warehouse).
If it is desirable to order a number of items together so a production run is made up (A good

example of this is a regional distribution center that orders a truck load once a week from a
central warehouse).
Valuing Inventory
There are four different ways to value inventory
1. Specific Identification
2. FIFO (First In, First Out)
3. LIFO (Last In, First Out)
4. Average Cost
Specific Identification
Used when each the cost of each individual unit is tracked. Example: Buildings, Land, Heavy
Equipment, Automobiles. Usually very few items are sold for a high price. Why wouldn't specific
identification work for a company that sells paper clips? Cost of goods sold is simply to total of
the actual cost of each item sold during the year.
Other Inventory Assumptions
When it isn't practical to track the cost of every item individually, then you have to make an
assumption about which units are sold first and thus constitute cost of goods sold.
This assumption doesn't necessarily reflect the physical flow of inventory.
FIFO (First In, First Out)
Assume that the first items that are purchased are the first to be sold.
Cost of Goods Sold are the oldest units.
Ending Inventory are the newest units.

LIFO (Last In, First Out)
Assume the last items purchased are the first to be sold.

Cost of Goods Sold are the newest units.
Ending Inventory are the oldest units.
Average Cost Flow
As goods are purchased, an average unit price is calculated.

When goods are sold, the cost of goods sold is the units sold times the average cost.
Conceptual Comparison
LIFO gives a better reflection of current inventory costs with current sales.
FIFO gives a better inventory value on the balance sheet because the most recently purchased
items are included on the balance sheet.
Physical Distribution
Physical distribution is responsible for the movement or flow of materials from the producer to
the consumer.
It is part of the supply-production-distribution system and as such is part of an integrated

materials management or logistics system.
Movement of materials is divided into two functions
1. Physical supply
2. Physical distribution
Physical Supply
The movement and storage of goods from suppliers to manufacturing (a function of Materials
Management).
Depending on the conditions of sale it is the responsibility of either the supplier or the customer
but in either case it will ultimately be a cost to the customer.
Physical Distribution
The movement and storage of finished goods from the end of production to the customer (a
function of Distribution Management).
The particular way that the goods move through warehouses, wholesalers, and retailers is referred
to as the distribution channel.

While it can be argued that one firm's physical supply is another firm's physical distribution,
frequently there are important differences, particularly as they relate to the bulk and physical
condition of raw materials and finished goods.
The transportation and logistics problems involved in moving and storing iron ore are quite
different from those that occur in moving sheet steel.
These differences influence the design of a logistics system and are important in deciding the
location of warehouses and factories.
Both physical distribution and physical supply shall be covered together here under the discussion
of physical distribution.
Importance of Physical Distribution
Physical distribution is vital in our lives.
Usually manufacturers, customers, and potential customers are widely dispersed geographically.
If manufacturers serve only their local market, they restrict their potential for growth and profit.
By extending its market, a firm is able to gain economies of scale in manufacturing, reduce the
cost of purchases by volume discounts, and improve its profitability.
To accomplish these ends requires a well-run distribution system.
Manufacturing adds form value to a product by taking the raw materials and creating something
of more use.
Distribution adds place value and time value by placing goods in markets where they are
available to the consumer at the time the consumer wants them.
Factors Influencing Material Movement
 The channels of distribution that the firm is using. For example, producer to wholesaler to
retailer to consumer.
 The types of markets served. Market characteristics such as the geographical dispersion of
the market, the number of customers, and the size of orders.
 The characteristics of the product, such as weight, density, fragility. and perish ability.
 The type of transportation available to move the material.
Physical Distribution System

Physical distribution is responsible for delivering to the customer what is wanted on time and
being able to do so at a minimum cost.
The objective of distribution management is to design and operate a distribution system that
achieves the required level of customer service and does so at least cost.
To do this, all activities involved in the movement and storage of goods must be organized into
an integrated system.
Activities in the Physical Distribution System
A system is a set of components or activities that interact and affect each other.
A car engine is a system and if any part malfunctions, the performance of the whole engine is
affected.
In a distribution system six interrelated activities affect customer service and the cost of
providing it.
1. Transportation
Involves the various methods of moving goods outside the firm's buildings.
For most firms transportation is the single highest cost in distribution, usually accounting for one-
third to two-thirds of distribution costs.
Transportation adds place value to the product.
2. Distribution Inventory
Includes all finished goods inventory at any point in the distribution system.
In terms of cost it is the second most important item in distribution, accounting for about 25-30%
of the cost of distribution.
Inventories create time value by placing the product close to the customer.
3. Warehousing
Used to store and manage inventory.
The management of warehouses involves such problems as site selection number of warehouses
in the system layout and methods of receiving, storing, and retrieving goods.
4. Materials Handling
Concerned with the movement and storage of goods inside the warehouse.

The type of materials handling equipment used affects the efficiency and cost of operating the
warehouse
Materials handling represents a capital cost and a trade-off exists between this capital cost and the
operating costs of the warehouse
5. Protective Packaging
Goods moving in a distribution system must be contained, protected and identified.
In addition. goods are moved and stored in packages and must fit into the dimension of the
storage spaces and the transportation vehicles.
6. Order Processing
Includes those activities involved in filling customer orders.
They represent a time element in delivery and are thus an important part of customer service.
Total-Cost Concept
The objective of distribution management is to provide the required level of customer service at
the least total system cost.
This does not mean that transportation costs or inventory costs or any one activity cost should be
a minimum but that the total of all cost should be a minimum.
What happens to one activity has an effect on other activities, total system cost, and the service
level.
Management must treat the system as a whole and understand the relationships between the
activities.
Example
Consider the interaction between inventory and transportation costs.
The cost of inventory in transit for a particular shipment is $100 per day.
Transport by rail costs $200 and the transit time is 10 days. However. the goods can be moved by
air at a cost of $1000 and will take 1 day to deliver.
Rail Air
Transportation cost $200 $1000

Inventory-carrying cost 1000 100
Total 1200 1100

Two Related Principles
Cost trade-off
The cost of transportation increased with the use of air transport but the cost of carrying inventory
decreased.
There was a cost trade-off between the two.
Total cost
By considering all the costs involved and not sub optimizing on any one cost, the total system
cost has been reduced.
Other Costs Must be Considered
Note also that while no cost has been attributed to it, customer service has potentially been
improved by reducing the transit time.
The total cost should also reflect the effect of the decision on other sections of the firm such as
production and marketing.
The preceding example does not mean that there will always be a saving by moving to faster
transport.
For example, if the goods being moved are of low value and inventory carrying cost is only $10
per day, then rail is cheaper.
Trade-Offs
Most of the decisions in distribution, and indeed much of what is done in business and in our own
lives, involves trade-offs and an appreciation of the total costs involved.
The emphasis is on the costs and trade-offs that will be incurred and on maximizing customer
service.
Generally, but not always, an increase in customer service requires an increase in cost, and this in
itself is a major trade-off required in the system.
Interfaces
By taking the goods produced by manufacturing and delivering them to the customer, physical
distribution provides a bridge between marketing and production.
As such, there are a number of important interfaces between physical distribution and production
and marketing.

Marketing
While physical distribution interacts with all departments in a business, the closest relationship is
probably with marketing.
In many cases it is thought of as a marketing subject and not as part of materials management or
logistics.
The "marketing mix" is made up of product, promotion, price, and place, and the latter is created
by physical distribution.
Marketing is responsible for transferring ownership.
Ownership transfer is accomplished by such methods as personal selling, advertising, sales

promotion, merchandising, and pricing
Physical distribution is responsible for giving the customer possession of the goods and does so
by operating warehouses, transportation systems, inventories, and order processing systems.
It has the responsibility of meeting the customer service levels established by marketing and the
senior management of the firm.
Physical distribution contributes to creating demand.
Prompt delivery, product availability, and accurate order filling are important competitive tools in
promoting a firm's products.
Also the distribution system is a cost, and its efficiency and effectiveness influences the
company's ability to price competitively. All these influence company profits.
Production
Physical supply establishes the flow of material into the production process.
Usually the service level must be very high because the cost of interrupted production schedules
caused by raw material shortage is usually enormous.
In some cases the location of factories is determined largely by the sources and transportation
links of raw materials.
This is particularly true where the raw materials are bulky and of relatively low value compared
to the finished product.
The location of steel mills on the Great Lakes is a good example.
The basic raw material, iron ore, is bulky, heavy, and of low unit value.

Transportation costs must be kept low to make a steel mill profitable.
Iron ore from mines in either northern Quebec or Minnesota is transported to the mills by boat,
the least cost mode of transportation.
Unless a firm is delivering finished goods directly to a customer, demand on the factory is created
by the warehouse orders and not directly by the final customer.
This can have severe implications on the pattern of demand on the factory.
While the demand from customers may be relatively uniform, the factory reacts to the demand
from the warehouses for replenishment stock.
If the warehouses are using an order point system, the demand on the factory will not be uniform
and in fact will be dependent rather than independent demand.
The distribution system is the factory's customer, and the way that the distribution system
interfaces with the factory will influence the efficiency of factory operations.
Transportation
Transportation is an essential ingredient in the economic development of any area
It brings together raw materials for production of marketable commodities and distributes the
products of industry to the marketplace.
It is a major contributor to the economic and social fabric of a society and aids economic
development of regional areas.
Modes of Transportation
 Rail
 Road including truck, bus, and automobile
 Air
 Water, including ocean going, inland and coastal
 Pipeline
 Multimodal (using 2 or more of the above 5 modes)

Cost and Service Characteristics
Each mode has different cost and service characteristics.
These determine the types of goods the mode will best move.
Certain types of traffic are simply more logically moved within one mode than they are in another.
Trucks are best suited to moving small quantities to widely dispersed markets but trains are best
suited to moving large quantities of bulky cargo such as grain.
Costs of Carriage
Any carrier, regardless of mode, must have certain basic physical elements to be able to provide
transportation service.
These elements include ways, terminals, and vehicles.
Each results in a cost to the carrier and, depending on the mode and the carrier, may be either
capital (fixed) or operating (variable) costs.
Fixed costs are costs that do not change with the volume of goods carried.
The purchase cost of a truck that is owned by the carrier is a fixed cost. No matter how much it is
used, the cost of the vehicle does not change.
Many of the costs of operation, such as fuel, maintenance, and driver's wages, depend on the use
made of the truck. These are variable costs.
Ways
Paths over which the carrier operates.
Include the right of way (land area being used) plus any roadbed tracks or other physical facilities
needed on the right of way.
The nature of the way and how it is paid for vary with the mode.
They may he owned and operated by the government or by the carrier or provided by nature.

Terminals
Places where carriers:
 Load and unload goods into and from vehicles and make connections between local pickup
and delivery service and line-haul service
 Weight loads
 Make connections with other routes and carriers are made
 Route, dispatch, and maintain vehicles
 Conduct administration and do paper work
The nature, size, and complexity of the terminal varies with the mode and size of the firm and the
types of goods carried.
Generally terminals are owned and operated by the carrier, but in some special circumstances they
may be publicly owned and operated.
Vehicles
Are used in all modes except pipelines.
Serve as carrying and power units to move the goods over ways.
Usually provided through ownership or leasing by the carrier, although sometimes the shipper
owns or leases them.
Miscellaneous
In addition to ways, terminals, and vehicles, a carrier will have other costs such as:
 Maintenance
 Labor
 Fuel
 Administration
These are generally part of operating costs and may be fixed or variable.
Rail
Railways provide their own ways, terminals, and vehicles.
These represent a large capital investment.
This means that a high proportion of the total cost of operating a railway is fixed.
Thus, railways must have a high volume of traffic in order to absorb the fixed costs.

They will not want to install and operate rail lines unless there is a large enough volume of traffic.
Trains move goods by train loads composed of perhaps a hundred cars each with a carrying
capacity in the order of 160,000 pounds.
Therefore, railways are best able to move large volumes of bulky goods over relatively long
distances.
Their frequency of departure will be less than trucks, which can move as soon as one truck is
loaded.
Rail speed is comparatively good over long distances, the service is generally reliable, and they
are flexible about the goods they can carry.
Train service is cheaper than road for large quantities of bulky commodities such as coal, grain,
potash, and containers moved over long distances.
Road
Trucks do not provide their own ways (roads and highways) but pay a fee to the government in
the form of license, gasoline. and other taxes and tolls for the use of roads.
Terminals are usually owned and operated by the carrier but may be privately owned, and, in
some cases are owned by the government.
Vehicles are owned, or leased, and operated by the carrier.
If owned, they are a major capital expense.
In comparison to other modes, the cost of a vehicle is small.
This means that for road carriers the majority of their costs are operating (variable) in nature.
Trucks can provide a door-to-door service as long as there is a suitable surface on which to drive.
In the United States and Canada the road network is superb.
The unit of movement is a truckload, which can be up to about 100,000 pounds.
These two factors, the excellent road system and the relatively small unit of movement, mean that
trucks can provide fast flexible service almost anywhere in North America.
They are particularly suited to distribution of relatively small volume goods to a dispersed market.

Air
Air transport does not have ways in the sense of fixed physical roadbeds, but it does require an
airway system that includes air traffic control and navigation systems.
These systems are usually provided by the Federal Government.
Carriers pay a user charge that is a variable cost to them.
Terminals include all the airport facilities, most of which are provided by the government.
Carriers are usually responsible for providing their own cargo terminals and maintenance
facilities, either by owning or renting the space.
The carrier provides the aircraft either through ownership or leasing.
The aircraft are expensive and are the single most important cost element for the airline.
Since operating costs are high, airlines tend to have a high proportion of their costs as variable.
The main advantage of air transport is speed of service, especially over long distances.
Cargo travels mainly in passenger aircraft, and thus many delivery schedules are tied to those of
passenger service.
The service is flexible about destination as long as there is a suitable landing strip.
Transportation cost for air cargo is higher than for other modes.
Air transport is most suitable for high-value low-weight cargo or emergency items.
Water
Waterways used by water carriers are provided by nature or by nature with the assistance of the
government.
The St. Lawrence Seaway system is an example of this.
The carrier thus has no capital cost in providing the ways but may have to pay a fee for using the
waterway.
Terminals may be provided by the government but are increasingly privately owned.
In either case the carrier will pay a fee to use them.
Thus terminals are mainly a variable cost.

Vehicles (ships) are provided by the carrier by ownership or leasing.
Thus they represent the major capital or fixed cost to the carrier.
The main advantage of water transport is low cost.
Operating costs are low, and since the ships have a relatively large capacity, the fixed costs can be
absorbed over large volumes.
Ships are slow and are door to door only if the shipper and the consignee are on a waterway.
Hence water transportation is most useful for moving low-value bulky cargo over relatively long
distances where waterways are available.
Pipelines
Pipelines are unique among the modes of transportation in that they move primarily gas, oil, and
refined products on any widespread basis.
As such, they are of little interest to most users of transportation.
Capital costs for ways and pipelines are high and are borne by the carrier, but operating costs are
very low.
Transportation
Legal Types of Carriage
Legally carriers are classified as public (for hire) or as private (not for hire).
In the latter case individuals or firms own or lease their vehicles and use them to move their own
goods.
Public transport, on the other hand, is in the business of hauling for others for pay.
All modes of transport have public and for-hire carriers.
For-Hire Carriers
Include Common Carriers and those which contract to a specified shipper. Both are subject to
economic and safety/health regulation by federal, state, or municipal governments.
The US Federal Government has ―deregulated‖ interstate carriers, and they are now permitted to
set their own tariffs/rates. The Federal Government provides only health/safety regulation for
these carriers.

Depending on the jurisdiction, economic regulation may be more or less severe, and in recent
years there has been a strong move on the part of government to reduce regulations.
Economic regulation has centered on three areas:
 Regulation of rates
 Control of routes and service levels.
 Control of market entry and exit
Private Carriers
Are not subject to economic regulation.
Like public (common) carriers, are regulated in such matters as public safety, license tees, and
taxes.
Common Carriers
Make a standing offer to serve the public at published rates available to all.
This means that whatever products they offer to carry will be carried for anyone desiring their
service.
With some minor exceptions, they can carry only those commodities they are licensed to carry.
For instance, a household mover cannot carry gravel or fresh vegetables.
Common Carriers Provide:
 Service available to the public.

 Service to designated points or in designated areas.
 Scheduled service.
 Service of a given class of movement or commodity.
Contract Carriers
Haul only for those with whom they have a specific formal contract of service.
They do not hold themselves out to serve the public (although some transportation companies
provide both contract carriers and common carriers using different branches of their business).
Contract carriers offer a service according to a contractual agreement signed with a specific
shipper.
The contract specifies the character of the service, performance, and charges.
Private Carriers

Own or lease their equipment and operate it themselves.
This means investment in equipment, insurance, and maintenance expense.
A company normally only considers operating its own fleet if the volume of transport is high
enough to justify the capital expense.
Service Capability of Legal Types of Carriage
Service capability depends on the availability of transportation service and this in turn depends on
the control that the shipper has over the transportation agency.
The shipper must go to the marketplace to hire a common carrier and is subject to the schedules
and regulations of that carrier.
Least control can be exercised over common carriers.
Shippers can exercise most control over their own vehicles and have the highest service capability
with private carriage.
Other Transportation Agencies
There are a number of transportation agencies that use the various modes or combinations of the
modes.
Some of these are the post office, freight forwarders, couriers. and shippers.
They all provide a transportation service, usually as a common carrier.
They may own the vehicles or they may contract with carriers to move their goods.
Usually they consolidate small shipments into large shipments to make economic loads.
Transportation Cost Elements
There are four basic cost elements in transportation:

1. Line haul
2. Pickup and delivery
3. Terminal handling
4. Billing and collecting
A knowledge of these costs enables a shipper to get a better price by selecting the right shipping
mode.
We will use motor transport as an example, but the principles are the same for all.

Goods either move directly from the shipper to the consignee or move through a terminal
In the latter case they are picked up in some vehicle suitable for short-haul local travel
They are then delivered to a terminal where they are sorted according to destination and loaded
onto highway vehicles for travel to a destination terminal
There they are again sorted, loaded on local delivery trucks and taken to the consignee.
Line-Haul Costs
When goods are shipped, they are sent in a moving container that has a weight and volume
capacity.
The carrier, private or for hire, has basic costs to move this container, and whether the container
is full or not these costs exist.
For a truck these include such items as gasoline, the driver's wages, and depreciation due to usage.
These costs vary with the distance traveled and not the weight carried.
The carrier has essentially the same basic costs whether the truck moves full or empty.
If it is half full the basic costs must be spread over only those goods in the truck.
Therefore total line-haul costs vary directly with the distance shipped and not upon the weight
shipped.
Suppose for a given commodity the line-haul cost is $3 per mile and the distance is 100 miles,
resulting in a total line-haul cost of $300.
If the shipper sends 50,000 pounds, the total line-haul cost is the same as if 10,000 pounds is sent.
However, the line-haul costs (LHC) per hundred weight (cwt) is:
LHC/cwt = 300/500 = $0.60 per cwt (for 50,000 lb -500 cwt)
LHC/cwt = 300/100 = $3 per cwt (for 10,000 lb-100cwt)
Thus the total line-haul cost varies with:
The cost per mile.

The distance moved.
However the Line-haul cost per hundred weight varies with:
The cost per mile.

The distance moved.
The weight moved.
The carrier has two limitations or capacity restrictions on how much can be moved on any one
trip:
The weight limitation.

The cubic volume limitation of the vehicle.
With some commodities their density is such that the volume limitation is reached before the
weight limitation.
If the shipper wants to ship more, a method of increasing the density of the goods must be found.
This is one reason some light products are made so they nest (e.g. Styrofoam cups) and bicycles
and wheelbarrows are shipped in an unassembled state.
It is not done to frustrate us poor mortals who try to assemble them but to increase the density of
the product so more weight can be shipped in a given vehicle.
The same principle applies to goods stored in warehouses.
The more compact they are the more can be stored in a given space.
Therefore if shippers want to reduce transportation cost they should:
 Increase the weight shipped.
 Maximize density.
Pickup and Delivery Costs
Are similar to line-haul costs except that the cost depends more on the time than on the distance
traveled.
The carrier will charge for each pickup and for the weight picked up.
If a shipper is making several shipments it will be less expensive if they are consolidated and
picked up on one trip.
Terminal Handling Costs
Terminal handling costs depend upon the number of times a shipment must be loaded, handled,
and unloaded
If full truckloads are shipped, the goods do not need to be handled in the terminal but can go
directly to the consignee.

If part loads are shipped, they must be taken to the terminal, unloaded, sorted, and loaded onto a
highway vehicle.
At the destination the goods must be unloaded, sorted, and loaded onto a local delivery vehicle.
Each individual parcel must be handled.
A shipper who has many customers each ordering small quantities will expect the terminal
handling costs to be high because there will be a handling charge for each package.
The basic rule for minimizing terminal handling costs is to minimize handling effort by
consolidating shipments into fewer parcels.
Billing and Collecting Costs
Every time a shipment is made, paperwork has to be done and an invoice made out.
Billing and collecting costs can be reduced by consolidating shipments and reducing the pickup
frequency.
Total Transportation Costs
The total cost of transportation consists of line-haul, pickup and delivery, terminal handling, and
billing and collecting costs
To minimize shipping costs, the shipper will:
 Decrease line-haul costs by increasing the weight shipped.

 Decrease pickup and delivery cost by reducing number of pickups (by consolidation and
increasing the weight per pickup).
 Decrease terminal handling costs by decreasing number of parcels by consolidating
shipments.
 Decrease billing and collecting costs by consolidating shipments.
For any given shipment the line-haul costs vary with the distance shipped.
The other costs are fixed
The total cost for any given shipment thus has a fixed cost and a variable cost associated with it.
The carrier will take this relationship into account and either charge a fixed cost plus so much per
mile or often a tapered rate.
In the latter case the cost per mile for short distances far exceeds that for longer distances.
The rate charged by a carrier will also vary with the commodity shipped and will depend upon the
following:

 Value. A carrier's liability for damage will be greater the more valuable the item.
 Density. The more dense the item, the greater the weight that can be carried in a given
vehicle.
 Perish ability. Perishable goods often require special equipment and methods of handling.
 Packaging. The method of packaging affects the risk of damage and breakage.

Rate Structures
Carriers have two rate structures:

 One based on full loads called truckload (TL) or car load (CL).
 One based on less than truckload (LTL) and less than car load (LCL).
For any given commodity the LTL rates can be up to 100% higher than the TL rates.
The basic reason for this differential lies in the extra pickup and delivery, terminal handling and
billing, and collection costs.
Truckers, airlines, and water carriers accept less than full loads, but usually the railways do not
accept LCL shipments.
Transportation Costs and the Total System
Any distribution system should try to provide the highest service level—the number of orders
delivered in a specified time—at the lowest possible cost.
The particular shipping pattern will depend largely upon the following:
 Number of customers.
 Geographic distribution of the customers.
 Customer order size.
 Number and location of plants and warehouses.
Suppliers have little or no control over the first three but do have some control over the last
They can establish local warehouses in their markets
With respect to transportation it then becomes a question of the cost of serving customers direct
from the central warehouse or from the regional warehouse
Example
If truckload shipments are made the cost is less from the central warehouse but if LTL shipments
are made it is usually cheaper to serve the customer from the local warehouse.
Suppose a company has a plant located in Toronto and is serving a market in the northeastern
United States with a large number of customers located in Boston.
If they ship direct to customers from the Toronto plant most shipments will be less than truckload.
However if they locate a warehouse in Boston they will he able to ship truckloads (TLs) to
Boston and distribute by local cartage (LTL) to customers in that area.

Whether this is economical or not depends on the total cost of shipping direct as against shipping
via the warehouse.
Assume the following figures represent the average shipments to the Boston area:
Plant to customer LTL $100/cwt

Plant to warehouse TL: $50/cwt
Inventory-carrying cost (warehouse): $10/cwt
Warehouse to customer LTL: $20/cwt
The cost of shipping LTL direct is $100/cwt and the cost of shipping TL to the warehouse and
LTL locally is $80/cwt, a saving of $$20/cwt.
Now suppose there are customers in Albany. They can be served LTL direct from the Toronto
plant or LTL from the warehouse in Boston.
Assume the following figures are representative:
Plant to CUSTOMER LTL: $90/cwt

Plant to warehouse TL: $50/cwt
Inventory carrying cost (warehouse): $10/cwt
Warehouse to customer LTL: $30/cwt
Either way the cost is the same and a cost equalization point for transportation costs has been
reached.
Similarly the location of other markets at the cost equalization point can be calculated.
In this way the areas served by the warehouse and the factory can be defined.
Effect on Transportation Costs of Adding More Warehouses
We have seen from the example in the previous section that establishing a warehouse in Boston
reduces total transportation costs.
Similarly if a second warehouse is established perhaps in Cleveland we expect total transportation

costs to reduce further.
Generally as more warehouses are added to the system we can expect the following:
 The cost of truckload (and car load) shipments to the warehouses to increase.
 The cost of LTL shipments to customers to decrease.
 The total cost of transportation to decrease.
As expected, the major savings is from the addition of the first few warehouses.
Eventually, as more warehouses are added, the savings decrease.

The first warehouse added is located to serve the largest market, the second warehouse the second
largest market, etc.
The number of customers served by additional warehouses decreases, and the volume that can be
shipped TL to the additional warehouses is less than to the first warehouses.
Warehousing and Distribution Inventory
Warehousing
Warehouses permit high-volume transportation over long distances between factory and markets.
Strategically locating regional warehouses in market areas minimizes the high cost of small-
volume shipments from the plant to individual customers.
Warehouses also improve service levels by locating inventory close to the customer for quick
delivery. They thus serve both a transportation and marketing purpose.
Types of Warehouses
 Plant warehouses
 Regional warehouses
 Local warehouses
Warehouses may be owned and operated by the supplier or middlemen such as wholesalers or
may be public warehouses.
The latter offer a general service to their public that includes providing storage space and
warehouse services
Some warehouses specialize in the kinds of services they offer and the goods they store.
A freezer storage is an example.
The service functions warehouses perform can be classified into two kinds
 The General warehouse

 The Distribution warehouse
General Warehouse
Where goods are stored for relatively long periods and where the prime purpose is to protect
goods until they are needed.
There is little handling, little movement, and little relationship to transportation.
Furniture storage or a depository for documents are examples of this type of storage.
It is also used for inventories built in anticipation of seasonal sales.

Distribution Warehouse
Has a dynamic purpose-movement and mixing.
Goods are received in large-volume uniform lots stored briefly, and then broken down into small
individual orders of different items required by customer in the marketplace.
The emphasis is on movement and handling rather than on storage.
This type of warehouse is widely used in distribution systems.
The size of the warehouse is not so much its physical size as it is the throughput or volume of
traffic handled.
Characteristics of Warehousing
As with other elements in a distribution system the objective of a warehouse is to minimize cost
and maximize customer service.
The costs of operating a warehouse can be broken down into capital and operating costs.
Capital costs are basically those of space and materials handling equipment.
The space needed depends on the peak quantities that must be stored, the methods of storage, and
the need for ancillary space for aisles, docks, offices, and so on.
The major operating cost is labor and the measure of labor productivity is the number of units (e.g.
cases) that an operator can move in a day.
This depends on the type of materials handling equipment used, the location and accessibility of
stock, warehouse layout, stock location system, and order-picking system used.
Objectives of Warehousing
Provide timely customer service.
Keep track of items so they can be found readily and correctly.
Minimize the total physical effort and thus the cost of moving goods into and out of storage.
Provide communication links with customers.

Warehouse Activities
To operate a warehouse there are several processing activities that have to take place and the
efficient operation OF the warehouse depends upon how well these are performed:
Receive the Goods. The warehouse accepts goods from outside transportation or an attached
factory and accepts responsibility for them. The warehouse must:
Check the goods against an order and the bill of lading

Check the quantities
Check for damage and if necessary fill out damage reports
Perform inspection if required
Identify the Goods. The item must be identified with the appropriate stock-keeping unit (SKU)
number (part number) and the quantity received recorded.
Dispatch Goods to Storage. The goods must he sorted and put away.
Hold Goods. The goods are kept in storage and under proper protection until needed.
Pick Goods. Items required from stock must be selected from storage and brought to a
marshalling area
Marshall the Shipment. The goods making up a single order must be brought together and
checked tor omissions or errors. Order records must be updated.
Dispatch the Shipment. The order must be packaged, shipping documents prepared, and the goods
loaded on the right vehicle.
Operate an Information System. For each item in stock a record must be maintained of the
quantity in stock, received, and issued and where the SKU is located in the warehouse.
In various ways all of these activities take place in any warehouse.
The complexity depends on the number of SKUs handled, the quantities of each SKU, and the
number of orders received and filled.
With any particular mix, to maximize productivity and minimize cost, warehouse management
must be concerned with the following:
 Maximum use of space.

 Effective use of labor and equipment.

Maximum Use of Space
Usually the largest capital cost is for space.
This means not only floor space but cubic space as well since goods are stored above the floor as
well as on it.
Effective Use of Labor and Equipment
Materials handling equipment represents the second largest capital cost and labor the largest
operating cost.
There is a trade-off between the two in that labor costs can be reduced by the use of more
materials handling equipment.
Warehouse management will need to ensure the following:
 Selection of the best mix of labor and equipment to maximize the overall productivity of the
operation.
 Provision of ready access to all SKUs, insuring that the SKUs should be easy to identify and
find. This requires a good stock location system and layout.
 Efficient movement (material handling) of goods
Factors Influencing Effective use of Warehouses
 Cube utilization and accessibility

 Stock location
 Order picking and assembly
 Packaging
Cube Utilization and Accessibility
Space is required in a warehouse not only for storage but also, for example, for aisles, receiving
and shipping docks, offices, and order picking and assembly.
In calculating the space needed for storage, some design figure for maximum inventory is needed.
Suppose that a maximum of 900,000 cartons are to be inventoried and that 30 cartons fit on a
pallet. Space is needed for 30,000 pallets and if pallets are stacked three high, then 10,000 pallet
positions are required. A pallet is a platform usually measuring 48 x 40 x 4 in.
Example
Assume a warehouse with dock space 10' X 20', storage space #1, 120' X 4', aisle space 120' X 12'
and storage space #2, 120' X 4'
The pallets cannot be placed tight against one another because then they cannot be moved.

A 2-in. clearance must be allowed between them. There is then room for 34 pallet positions along
each wall.
Since the pallets are stacked three high there is room for 34 x 3 x 2 = 204 pallets.
As long as all pallets contain the same SKU there is no problem with accessibility.
The SKU can be reached without moving any other product.
However. if a number of SKUs are stored in the area, we want each product to be accessible with
a minimum of difficulty.
With different SKUs, stacking of pallets or some other procedure must be used to maximize
space utilization.
Stock Location
Stock location or warehouse layout is concerned with where individual items are located in the
warehouse.
There is no single universal stock location system suitable for all occasions. But there are a
number of basic systems that can be used.
Which system or mix of systems is used depends upon the type of goods being stored, the type of
storage facilities required, the throughput, and the size of orders.
Whatever the system, management will want to maintain enough inventory of safety and working
stock to provide the required level of customer service, be able to keep track of items so they can
be found easily and minimize the total effort required to receive goods, put them away, and
retrieve them for shipment.
Basic Systems of Locating Stock
Group Functionally Related Items Together. Group together those items that are similar in their
use (functionally related)--For example put all hardware items in the same area of the warehouse.
If Functionally-related items are ordered together this makes the order picking easier. Warehouse
personnel will become familiar with where items are located and this will reduce errors
Group Fast-Moving Items Together. If fast-moving items are placed relatively close to the
receiving and shipping area, the work of moving them into and out of storage will be minimized.
Slower moving items can be placed in more remote areas of the warehouse.
Group Together Physically Similar Items. Often physically similar items require their own
particular storage facilities and handling equipment. Small packaged items may require shelving

while heavy items such as tires or drums require different facilities and handling equipment.
Frozen Foods have to be stored together in a freezer.
Locate Working Stock and Reserve Stock Separately. Relatively small quantities of working
stock—the stock from which withdrawals are made, can be located close to the marshalling and
shipping area while reserve stock used to replenish the working stock can be located more
remotely.
Systems for Assigning Specific Locations to Individual Stock Items
 Fixed location
 Floating location
Fixed Location
In this system an SKU is assigned a permanent location or locations and no other items are stored
there.
This system makes it possible to store and retrieve items with a minimum of record keeping.
In some small manual systems no records are kept at all.
It is a little like the kitchen cupboards at home where cold cereal boxes are always put away and
retrieved from the same shelf.
Everything is nice and simple so one can always find things.
Fixed-location systems usually have poor cube utilization.
If demand is uniform presumably the average inventory is half the order quantity and enough
space has to be allocated for a full-order quantity.
Hence, on the average, we could expect about 50%cube utilization.
Fixed-location systems are often used in relatively small warehouses where space is not at a
premium, where throughput is small, and where there is a relatively small number of SKUs.
Floating Location
In this system goods are stored wherever there is appropriate space for them.
This means that the same SKU may be stored in several locations at the same time and different
locations at different times.
The advantage to this system is improved cubic utilization.

However it requires accurate and up-to-date information on item location and the availability of
empty storage space so items can be put away and retrieved efficiently.
Modern warehouses using floating-point systems are usually computer-based and a computer
assigns free locations to incoming items, remembers what items are on hand and where they arc
located, and directs the order picker to the right location to find the item.
Thus cube utilization and warehouse efficiency are greatly improved.
Systems of Order Picking and Assembly
Area System
The order picker circulates throughout the warehouse selecting the items on the order, much as a
shopper would in a supermarket.
The items are then taken to the shipping area for shipment.
The order is self-marshalling in that when the order picker is finished, the order is complete.
This system is generally used in relatively small warehouses where goods are stored in a fixed
location.
Modified Area System
This system operates as the area system except that the working stock and the reserve stock are
separated.
A separate work force is used to replenish the working stock from the reserve stock.
Zone System
The warehouse is broken down into zones and each order picker (or group of pickers) works only
in his or her own area.
An order is divided up by zone and each order picker selects those items in his or her zone and
sends them to the marshalling area where the order is assembled for shipment.
Each order is handled separately and leaves the zone before another is handled.
Sequential Zone System
The order is broken down into zones and then passed from zone to zone as it is picked.
By the time it exits the last zone, it is assembled for shipment.
Multiorder System

This system is the same as the zone system except that rather than handling individual orders, a
number of orders are gathered together and all the items divided by zone.
The picker then circulates through his or her area collecting all the items required for that group
of orders.
The items are then sent to the marshalling area where they are sorted to individual orders for
shipment.
The multiorder system is simple to manage and control, but as the warehouse throughput and size
increase it becomes unwieldy.
The zone systems break down the order-filling process into a series of smaller areas that
individually can be better managed.
The multiorder system is probably most suited to the situation where there are many items or
many small orders with few items.
Packaging
The basic role of packaging in any industrial organization is to carry the goods safely through a
distribution system to the customer.
In doing so the package must do the following:
1. Identify the product.
2. Contain and protect the product.
3. Contribute to physical distribution efficiency.
For consumer products the package may also be an important part of the marketing program.
Physical distribution must not only move and store products but also identify them.
The package serves as a means of identifying the product in a way that is not possible from its
outward appearance.
When shoes are offered in 10 sizes, the package becomes an important identifier.
Packaging must contain and protect the product, often against a wide range of hazards such as
shock, compression, vibration, moisture, heat, solar radiation, oxidation, infestation by animals,
insects or birds, mold, and bacteria.
Packages are subject to distribution hazards in loading and off-loading, in movement, in

transportation, and in warehousing and storage.

The package must be robust enough to protect and contain the product through all phases of
distribution.
Packaging is a pure cost that must be offset by the increased physical distribution efficiency that
the package can provide.

There are usually at least three levels of packaging required in a distribution system
1. A primary package that holds the product—the box of cereal.

2. For small packages, a shipping container such as a corrugated box is also needed.
3. A third level of packaging where several primary or secondary packages are assembled into a
unit load may also be needed.
Unitization
Defined as the consolidation of several units into large units, called unit loads, so there is less
handling.
Unit load is a load made up of a number of items, or bulky material, arranged or constrained so
the mass can be picked up or moved as a single unit too large for manual handling.
Material handling costs decrease as the size of the unit load increases so it is more economic to
move the product by cartons rather than individually and still more economic to move several
cartons in one unit load.
This principle is used time and again when we go shopping and put a number of articles into bags
and in turn put the bags into the trunk of the car.
In industry, unit loads are used instead of shopping bags.
There are a number of unit-load devices such as sheets, racks, or containers.
One of the most common is the pallet--The pallet is a platform usually measuring 48 x 40 x 4
inches and designed so that it can be lifted and moved by a fork lift industrial truck.
Packages are arranged on it so that several packages may be moved at one time.
Loaded with packages, it forms a cube that is a unit load.
Unitization can be successive.
Shippers place their products into primary packages, the packages into shipping cartons, the
cartons onto pallets, and the pallets into warehouses, trucks, or other vehicles.
To use the capacity of pallets, trucks (or other vehicles), and warehouses, there should be some
relationship between the dimensions of the product, the primary package, the shipping cartons,
the pallet, the truck, and the warehouse space.
The packages should be designed so space on the pallet is fully utilized and so the cartons
interlock to form a stable load.
Pallets fit into trucks and railway cars.

The dimensions mentioned earlier, were selected so pallets would fit into nominal 50-foot railway
cars and 40-foot truck trailers with a minimum of lost space.
Thus, to get the highest cube utilization, consideration must be given to the dimensions of the
product, the carton. the pallet, the vehicle, and the warehouse.
Distribution Inventory
Distribution inventory includes all the finished goods held anywhere in the distribution system.
The purpose of holding inventory in distribution centers is to improve customer service by

locating stock near the customer and to reduce transportation costs by allowing the manufacturer
to ship full loads rather than part loads over long distances.
Objectives of Distribution Inventory
Provide the required level of customer service.
Minimize the costs of transportation and handling.
Able to interact with the factory to minimize scheduling problems.
Distribution Inventory Systems
Distribution systems vary considerably, but in general they have a central supply facility that is
supported by a factory, a number of distribution centers, and finally customers.
Customers may be the final consumer or some intermediary in the distribution chain.
Unless a firm delivers directly from factory to customer, demand on the factory is created by
central supply.
In turn, demand on central supply is created by the distribution centers.
This can have severe repercussions on the pattern of demand on central supply and the factory.
While the demand from customers may be relatively uniform, the demand on central supply is not.
It is dependent upon when the distribution centers place replenishment orders.
In turn, the demand on the factory depends on when central supply orders.
The distribution system is the factory's customer, and the way that the distribution system
interfaces with the factory has a significant effect on the efficiency of factory operations.
Distribution inventory management systems can be classified into pull, push, and distribution
requirements planning systems.

Pull System
Each distribution center first determines what it needs and when and then places orders on central
supply--Each center orders on its own without regard for the needs of other centers, available
inventory at central supply, or the production schedule of the factory.
The advantage is that each center can operate on its own and thus reduce communication and
coordination expense.
The disadvantage is the lack of coordination and the effect this can have on inventories, customer
service, and factory schedules.
Because of these deficiencies, many distribution systems have moved toward more central control.
There are a number of ordering systems that can be used, including the order point and periodic
review systems.
Orders are placed on central supply and "pulled" through the system.
Push System
In a push system all forecasting and order decisions are made centrally.
Stock is "pushed" out into the system from central supply.
Distribution centers have no say in what they receive.
Different ordering systems can be used, but in general an attempt is made to replace the stock that
has been sold and to provide For special situations such as seasonality or sales promotions.
These systems attempt to balance the available inventory with the needs of each distribution
center.
The advantage to these systems is the coordination between factory, central supply, and
distribution center needs.
The disadvantage is the inability to react to local demand, thus lowering the level of service.
Distribution Requirements Planning (DRP)
Distribution Requirements Planning (DRP) is a system of forecasting when the various demands
will be made by the system on central supply.
This gives central supply and the factory the opportunity to plan for the goods that will actually be
needed and when.

It has the ability to both respond to customer demand and coordinate planning and control.
The system translates the logic of material requirements planning to the distribution system.
Planned order releases from the various distribution centers become the input to the material plan
of central supply.
The planned order releases from central supply become the forecast of demand for the factory
master production schedule.
Materials Handling
Materials handling is the short-distance movement that takes place in or around a building such as
a plant or warehouse.
For a warehouse this means the unloading and loading of transport vehicles and the dispatch and
recall of goods to and from storage.
In addition, the racking systems used in warehouses are usually considered as part of materials
handling.
Objectives of Materials Handling
To increase cube utilization by using the height of the building and by minimizing the need for
aisle space as much as possible.
To improve operating efficiency by reducing handling. Increasing the load per move will result in
fewer moves.
To improve the service level by increasing the speed of response to customer needs.
Types of Material Handling Equipment
1. Conveyors
2. Industrial Trucks
3. Cranes and Hoists
Conveyors
Devices that move material (or people) horizontally or vertically between two fixed points.
They are expensive, create a relatively fixed route and occupy space continuously.
As a result, they are used only where there is sufficient throughput between fixed points to justify
their cost.

Industrial Trucks
Vehicles powered by hand, electricity, or propane.
Diesel and gasoline are not used indoors because they are noxious as well as lethal.
Industrial trucks are more flexible than conveyors in that they can move anywhere there is a
suitable surface and no obstructions.
They do not occupy space continuously.
They are the most often used form of materials handling in warehouses and in manufacturing.
Cranes and Hoists
Are able to move materials vertically and horizontally to any point within their area of operation.
They use overhead space and are used to move heavy or large items.
Within their area of operation they are very flexible.
Multiwarehouse Systems
We will look at the result of adding more warehouses to the system.
As might be expected. there is an effect on the cost of warehousing, materials handling,

inventories, and packaging as well as transportation.
Our purpose will be to look at how all of these costs and the total system cost behave.
We also want to know what happens to the service level as more warehouses are added to the
system.
Transportation Costs
In the section on transportation we saw that if shipments to customers are in less than full vehicle
lots, by establishing a warehouse in a market area the total transportation cost is reduced.
This is so because more weight can be shipped for greater distances by truck or car load and the
less than truckload shipments can be made over relatively short distances.
Generally, then, as more warehouses are added to a system we expect the following:
The cost of full-load shipments increases.
The cost of less than full-load shipments decreases.

The total cost of transportation decreases.
The major transportation savings are made with the addition of the first warehouses, and
eventually, as more warehouses are added, the marginal savings decrease.
Inventory-Carrying Cost
The average inventory carried depends upon the order quantity and the saeety stock.
The average order quantity inventory in the system should remain the same since it depends upon
demand, the cost of ordering, and the cost of carrying inventory.
Safety stock will be affected.
With a constant sales volume, as the number of warehouses increases, the demand on each
decreases---this causes an increase in the total safety stock in all warehouses.
Warehousing Costs
The fixed costs associated with warehouses are space and materials handling.
The space needed depends upon the amount of inventory carried.
As we have seen, as more warehouses are added to the system, more inventory has to be carried.
This requires more space.
In addition, there will be some duplication of nonstorage space such as washrooms, offices, and
so on.
The result is that as the number of warehouses increases, there will be a gradual increase in
warehouse space cost.
Operating costs also increase as the number of warehouses increases.
Operating costs depend largely on the number of units handled.
Since there is no increase in sales, the total number of units handled remains the same, as does the
cost of handling.
However, the non-direct supervision and clerical costs increase.
Material Handling Costs
Material handling costs depend upon the number of units handled.

Since the sales volume remains constant, the number of units handled should also remain
constant.
Material handling costs are relatively constant as long as the firm can ship unit loads to the
warehouse.
But if the number of warehouses increases to the point that some nonunitized loads are shipped,
then it follows that material handling costs increase.
Packaging Costs
Per unit packaging costs will remain the same.
But since there will be more inventory, total packaging costs will rise with inventory.
Total System Cost
A valid comparison can thus be made.
We have assumed that total system sales remain the same.
Up to a point total costs decrease and then start to increase.
It is the objective of logistics and supply chain management to determine this least cost point.
System Service Capability
The other side of the coin is the service capability of the system.
One way of approaching this is by estimating the percentage of the market that is served within a
given period.
As expected, the service level increases as the number of warehouses increases.
It increases rapidly from one to two warehouses and much less rapidly as the number is further
increased.
Just-in-Time Manufacturing (JIT)
In the past 20 years manufacturing has become much more competitive, not just in North
America but globally.
Countries such as Japan and others on the Pacific Rim are able to produce goods of consistently
superior quality and deliver them to North American markets at a competitive price and on time.
They have responded to changing market needs and in many cases have detected those needs
before the consumer.

The Walkman, developed by Sony, is an example of Japanese market awareness.
Because of such competition, North America has lost the edge in the manufacture of such goods
as radios, televisions, cameras, and shipbuilding.
How have the Japanese been able to do this?---It has nothing to do with culture, geography,
government assistance, new equipment, or cheap labor.
What it does have to do with is a practice referred to as just-in-time manufacturing.
Just-in-Time Manufacturing (JIT) is a philosophy that relates to the way a manufacturing

company organizes and operates its business.
It is not a magic formula or a set of new techniques that suddenly makes a manufacturer more
productive.
Rather it is the very skillful application of existing industrial and manufacturing engineering
principles.
Japanese have not taught us new tricks but have forced us to look at manufacturing with a
different philosophy.
Just-in-Time Philosophy
Just-in-time manufacturing can be defined in many ways, but the most popular is the elimination
of waste.
Waste is defined as anything other than the minimum amount of equipment, parts, space, material,
and workers' time that is absolutely necessary to add value to the product.
This means there should be no surplus, there should be no safety stocks, and lead times should be
a minimum: "If you can't use it now, don't make it now."
Value
What is of value to the user?
It is having all the right parts and quantities at the right time and place.
It is having a product or service that does what the customer wants, does it well and consistently,
and is available when the customer wants it.
Value satisfies the actual and perceived needs of the customer and does it at a price the customer
can afford and feels is reasonable.
Another word for this is quality.

Quality is meeting and exceeding the customers' expectations.
Value starts in the marketplace where marketing must decide what the customer wants.
Design engineering must design the product so it will provide the required value to the customer.
Manufacturing engineering must design a process to make the product, and then manufacturing
must build the product according to these specifications.
The loop is complete when the product is delivered to the customer.
Adding value to a product does not mean adding cost.
Users are not concerned with the manufacturer's cost but only with the price they must pay and
the value they receive.
There are many activities that increase cost without adding value, such as counting, moving,
storing, expediting, searching for, and inspection--As much as possible, these activities should be
eliminated.
Adding cost is waste. Anything in the product cycle that does not add value to the product is
waste.
Waste Caused by Poor Product Specification and Design
The making of waste starts with the policies that management sets to respond to the needs of the
marketplace.
Management is responsible for establishing policies for the market segments that they wish to
serve and for determining how specialized the product line is to be.
These policies affect the costs of manufacturing.
For example, if the range and variety of product is large, production runs will be short and
machines will have to be changed over frequently.
There will be little opportunity to use specialized machinery and fixtures.
On the other hand, a company with a limited product range can likely produce goods on an
assembly line basis and take advantage of special-purpose machinery.
In addition, the greater the diversity of products, the more complex the manufacturing process
becomes, and the more difficult it is to plan and control.
There is a way that companies can specialize in the products they make and at the same time offer
the customer a wide range of options.

This is to standardize the component parts that are used in the different models they make.
They can then supply the customer with a wide variety of models and options made from standard
components.
Parts standardization has a number of advantages in manufacturing.
It creates larger quantities of specific components that permit longer production runs.
This in turn makes it more economic to use more specialized machinery, fixtures, and assembly
methods.
Standardization reduces the planning and control effort needed, the number of items required, and
the inventory that has to be carried.
The "ideal" product is one that meets or exceeds the needs of the customer, makes the best use of
material, and can be manufactured with a minimum of waste (at least cost).
As well as satisfying the customer, the product's design determines both the basic manufacturing
processes that have to be used and the cost and quality of the product.
The product should be designed so it can be made on the most productive process and so there is
a minimum number of operations and motions needed in manufacture and assembly.
There should be as few parts as possible.
The product should not be "overdesigned".
The designer must be careful about features that are important to the customer but should avoid
over specifying features that are not: "Don't gold plate when chrome will do!"
Waste Caused in Manufacturing
Manufacturing takes the design and specifications of the product and, using the manufacturing
resources, converts them into useful products.
But first manufacturing engineering must design a system capable of making the product.
This is done by selecting the manufacturing steps and the machinery and equipment and by
designing the plant layout and work methods.
Manufacturing must then plan and control the operation to produce the goods.
This involves manufacturing planning and control, quality management, maintenance, and labor
relations.

There are several sources of waste in this series.
The Toyota company has identified seven important sources of waste. The first four relate to the
design of the manufacturing system and the last three to the operation and management of the
system:
The Process. The best process is one that has the capability to consistently make the product
with an absolute minimum of scrap in the quantities needed and with the least cost added. Waste,
or cost, is added to the process if the wrong type or size of machines are used, if the process is not
being operated correctly, or if the wrong tools and fixtures are used.
Methods. Waste is added if the methods of performing tasks By the operators cause wasted
movement, time, and effort. Activities that do not add value to the product should be eliminated.
Searching for tools, walking, or unnecessary motions are all examples of waste.
Movement. Moving and storing components does not add value. For example, goods received
may be stored and then issued to production. This requires labor to put away, find, and deliver to
production; records must be kept and a storage system maintained; all these add cost without
adding value to the product. Poorly planned layouts may make it necessary to move product
over long distances; this increases the movement cost and, as well, may add to storage and
record-keeping costs,
Product Defects. Defects interrupt the smooth flow of work. If the scrap is not identified, the
next work station receiving it will waste time trying to use the detective parts or waiting for good
material. Schedules will have to be adjusted. If the next step is the customer, then the cost will
be even higher. Sorting out or reworking defects are also waste.
Waiting Time. There are two kinds of waiting time, that of the operator and that of material. If
the operator has no productive work to do or there are delays in getting material or instructions,
then there will be waste. Ideally, material passes from one work center to the next and is
processed without waiting in queue.
Overproduction. Overproduction is producing product over and above that needed for
immediate use. When this occurs, raw material and labor are consumed for unneeded work
resulting in unnecessary inventories. Considering the costs of carrying inventory, this can be
very expensive. Overproduction causes extra handling of material and extra planning and
control effort and leads to quality problems. Because of the extra inventory and work in process,
overproduction adds confusion, tends to bury problems in inventory, and often leads to producing
components that are not needed instead of working on those that are needed. Overproduction is
not necessary as long as market demand is met. Machines and operators do not always need to
be fully utilized.
Inventory
Inventory costs money to carry and excess inventory adds extra cost to the product.
However, there are other costs in carrying excess inventory.

A better product suggests one that has features and quality superior to others.
The ability to take advantage of product improvement opportunities depends on the speed with
which engineering changes and improvements can be implemented.
If there are large quantities of inventory to work through the system, it takes longer and is more
costly before the engineering changes reach the marketplace.
Lower inventories improve quality.
Companies can offer better prices if their costs are low.
Lower inventories reduce cost.
Also, if work-in-process inventory is reduced, then less space is needed in manufacturing,

resulting in cost savings.
Responsiveness to the marketplace depends on being able to provide shorter lead times and better
due date performance..
Manufacturing lead time depends on queue and queue depends on the number and the batch size
of the orders in process.
If batch size is reduced, then so will the queue and lead time.
Forecasts are more accurate for nearer periods of time--reducing lead time improves forecast
accuracy and provides better order-promising and due date performance.
Just-in-Time Environment
There are a number of elements that are characteristic of a JIT environment.
They may not all exist in a particular manufacturing situation.
In general they provide a number of principles to help in the development of a JIT system. These
can be grouped as:
 Flow Manufacturing
 Process Flexibility
 Total Quality Control
 Uninterrupted Flow
 Supplier Relations
 Employee Involvement
Flow Manufacturing

The just-in-time concept was developed by companies like Toyota and some of the major
appliance and consumer electronic manufacturers.
These companies manufacture goods in a repetitive manufacturing environment.
Repetitive manufacturing is the production of discrete units on a line flow basis.
In this type of system the work stations required to make the product, or family of products, are
located close together and in the sequence needed to make the product.
Work flows from one work station to the next at a relatively constant rate and often with some
material handling system to move the product.
These systems are suitable for a limited range of similar products such as automobiles, televisions,
or microwave ovens.
Because work centers are arranged in the sequence needed to make the product, the system is not
suitable for making a wide variety of different products.
Demand for the family of products must be large enough to economically justify setting up the
line.
Flow systems are cost-effective because:
Work stations are designed to produce a limited range of similar products, machinery and tooling
can be specialized.
Material flows from one work station to the next, there is very little buildup of work-in-process
inventory.
Manufacturing lead times are short because of the low work-in-process inventory.
In their purest form flow lines are inflexible.
They can only produce a limited family of similar parts, and the quantity must be sufficient to
economically justify its use.
Because it is so cost-effective, this system of manufacturing should be used wherever and to

whatever extent possible.
Work Cells
Many companies do not have a product line that lends itself to flow manufacturing.
The quantities of specific parts are not sufficient to warrant it.
Companies with this kind of product line usually organize their production on a functional basis.

This means that the same or similar operations are grouped together.
Lathes will be placed together as will milling machines, drills, and welding equipment.
Product moves from one work station to the other in lots or batches.
This type of production produces long queues, high work-in-process inventory, and long lead
times as well as considerable materials handling.
Very often this kind of layout can be improved. It depends on the ability to detect product flows.
This can be done by grouping products together into product families.
Products will be in the same family if they use common work flow or routing, materials, tooling,
setup procedures, and if possible, cycle times.
Work stations can then be set up in miniature flow lines or work cells.
Parts can pass one by one, or in very small lots, from one work station to the next.
This has a number of benefits:
 Queue and lead times going through the cell are reduced drastically.
 Production activity control and scheduling are simplified--The cell is one work center to
control as opposed to five in a conventional system.
 The floor space needed is reduced.
 Work cells permit high-variety, low-volume manufacturing to be repetitive.
To be really effective. product design and process design must work together.
Component standardization becomes even more important.
Process Flexibility
Process flexibility is desirable so the company can react swiftly to changes in the volume and the
mix of the products the company manufactures.
To achieve this, machinery must be flexible and there must be an ability to change over quickly
from one product to another.
Machine Flexibility
Machinery used should be flexible and inexpensive.
Here it often makes more sense to have two relatively inexpensive general-purpose machines than
one large, expensive special-purpose piece of equipment.

Smaller general-purpose machines can be adapted to particular jobs with appropriate tooling.
Having two instead of one makes it easier to dedicate one to a work cell. Ideally the machinery
should be low cost and movable.
Setup
To have process flexibility, it is essential to be able to change quickly from one product to
another. This requires low setup times. In addition, low setup times also have the following
advantages:

Reduced Economic Order Quantity
Economic lot size depends on the setup cost.
If the setup time can be reduced, then the lot size can be minimized.
For example, if the economic order quantity is 100 units and the setup can be reduced to 25%,
then the economic order quantity decreases to 50.
Inventory is cut in half and queue and lead times are reduced.
Reductions in setup of this and greater magnitude are very possible.
The general opinion is that setup can be cut 50% by organizing the work and having the right
tools and fixtures available when needed.
For example, in one instance a changeover on a die press was videotaped.
The operator doing the changeover was not in view for more than 50% of the time.
He was away from the machine getting tools, dies, and so forth.
One system for setup reduction, called the "four-step method" claims that reductions of 90% can
be achieved without major capital expense.
This is accomplished by organizing the preparation, streamlining the setup, and eliminating
adjustments.
Reduced Queue and Manufacturing Lead Time
Manufacturing lead time depends mostly on the queue.
In turn, queue depends upon the order quantity and scheduling.
Reducing setup time reduces the order quantity and queue and lead times.
Reduced Work-in-Process (WIP) Inventory
Work-in-process inventory depends on the number of orders in process and their size.
If the order quantity is reduced, the WIP is reduced.
This frees up more floor space allowing work centers to be moved closer together.
This reduces handling costs and promotes the creation of work cells.

Improved Quality
When order quantities are small, defects have less time to be buried.
Because they are more quickly and easily exposed, there is more likelihood that their cause will
be detected and corrected.
Improved Process and Material Flow
Inventory acts as a buffer, burying problems in processes and in scheduling.
Reducing inventory reduces this buffer and exposes problems in the production process and in the
material control system.
This gives an opportunity to correct the problems and improve the process.
Total Quality Control
Quality starts in the marketplace
Quality Is defined as meeting or exceeding the users' expectations.
Quality is important for two reasons:
Quality is what is supplied to the customer, and if the product is defective, the customer will be
dissatisfied.
If a process produces scrap, it creates disrupted schedules that delay supplying the customer,
increases inventory or causes shortages, wastes time and effort on work centers, and increases the
cost of the product.
Who is the User?
Ultimately it is the company's customer--but the user is also the next operation in the process.
Quality at any one work center should meet or exceed the expectations (needs) of the next step in
the process. This is important in being able to maintain the uninterrupted flow of material.
If defects occur at one work center and are not detected until subsequent operations, then time
will be wasted and the quantity needed will not be supplied.
For manufacturing, quality does not mean inspection of the product to segregate good from bad
parts.
What manufacturing must do is be sure that defects will not be made in the first place.
This means that the process must be capable of producing the required quality consistently and
with as close to zero defects as possible.

Manufacturing must do all it can to improve the process to achieve this and then monitor the
process to make sure it remains in control.
Daily monitoring can best be done by the operator.
If defects are discovered, the process should be stopped and the cause of the defects corrected.
The benefits of a good-quality program:
 Less scrap
 Less rework
 Less inventory (inventory just in case there is a problem)
 Better on-time production
 Timely deliveries
 More customers who are more satisfied
For a process to continue to produce the required quality, machinery must be maintained in
excellent condition, and this can best be achieved through a program of preventive maintenance.
This is important for more reasons than quality.
Low Work-in-Process inventories means there is little buffer available.
If a machine breaks down, it will quickly have an effect on other work centers.
Preventive maintenance starts with daily inspections, lubrication, and cleanup.
Since operators usually understand how their equipment should "feel" better than anyone else, it
makes more sense to have them handle this type of regular maintenance.
Uninterrupted Flow
Ideally material should flow smoothly from one operation to the next with no delays.
This is most likely to occur in repetitive manufacturing where the product line is limited in
variety.
However, the concept should be worked toward in any manufacturing environment.
There are a number of conditions that are needed to achieve uninterrupted flow of materials.
Uniform Plant Loading
The work done at each work station should take about the same time.
In repetitive manufacturing this is called balancing the line.

This means that the time taken to perform tasks at each work station on the line is the same or
very nearly so.
This way there will be no bottlenecks and no buildup of work-in-process inventory.
Pull System
Demand on a work station should come from the next work station.
The pull system starts at the end of the line and pulls product from the preceding operation as
needed.
The preceding operation does not produce anything unless a signal is sent from the following
operation to do so.
The system for signaling demand depends on the physical layout and conditions in the plant.
The most well known pull system is Kanban.
The details vary about Kanban, but it is basically a two-bin, fixed-order quantity order point
system.
A small inventory of parts is held at the user operation, for example, two part bins.
When one bin is used up, it is sent back to the supplier and is the signal for the supplier operation
to make a container of parts.
Containers are standard size and contain a fixed number of parts (order quantity). This system
also makes the counting and control of WIP inventory much easier.
Valid Schedules
There should be a well-planned valid schedule.
The schedule sets the flow of materials coming into the factory and the flow of work through
manufacturing.
To maintain an even flow, the schedule must be level.
In other words, the same amount should be produced each day.
Furthermore, the mix of products should be the same each day.
For example, suppose a company makes a line of dog clippers composed of three models:
economy, standard, and deluxe.

The demand for each is 500, 600, and 400 per week, respectively, and the capacity of the
assembly line is 1500 per week.
The company can develop a schedule that will satisfy demand and will be level on the basis of
capacity.
However, inventory will build up, and if there is no safety stock, a variation in demand will create
a shortage.
For example, if there is a surge in demand for the deluxe model in week 1, none will be available
for sale in week 2.
An alternative schedule can reduce schedule inventory and the ability to respond to changes in
model demand can be increased.
The number of setups increases, but if setup times are reduced, this is not a problem.
The concept can be carried further by making something of each model each day. In this case it
would mean producing 100, 120, and 80 of each model each day.
If the line had complete flexibility, these could be produced in the following mixed sequence of
15. This is repeated 20 times during the day for a total output of 300:
E: Economy
S: Standard ESD, ESD, ESD, ESD, SES
D: Deluxe
The company makes something of everything each day in the proportions to meet demand.
Inventories are a minimum.
If demand shifts between models, the assembly line is able to respond daily. This is called mixed-
model scheduling.
The schedule is leveled, not only for capacity, but also for material.
Linearity
The emphasis on JIT is on achieving the plan, no more, no less.
This concept is called linearity and is usually achieved by scheduling to less than full capacity.
If an assembly line is capable of producing 100 units per hour, then it can be scheduled for
perhaps 700 units for an 8-hour shift.

If there are problems during the shift, there is extra time so the 700-unit schedule can be
maintained.
If there is time left over after the 700 units are produced, then it can be spent on jobs such as
cleanup, lubricating machinery, getting ready for the next shift, or solving problems.

Supplier Relations
If good schedules are to be maintained and the company is to develop a just-in-time environment,
then it is vital to have good reliable suppliers.
They establish the flow of materials into the factory.
The JIT philosophy places a lot of emphasis not only on supplier performance but also on
supplier relations.
Suppliers are looked upon as co-producers and not as adversaries.
The relationship between them should he one of mutual trust and cooperation.
The buyer expects that the supplier will:
Be able to supply the quality needed all the time so there will be no need for inbound inSspection-
-This implies that the supplier will have, or develop, an excellent process quality improvement
program.
Be able to make frequent deliveries on a Just-in-Time basis--This implies that the supplier will
become a jus-in-time manufacturer.
Be able to work with the buyer to improve performance, quality, and cost.
For a supplier to start to become a just-in-time supplier a long-term relationship must be

established.
Suppliers need to have that assurance so they can plan their capacity and make the necessary
commitment to a single customer.
In return, the supplier has the following benefits:
 Has a greater share of the business with long-term security.

 Is able to plan more effectively.
 Is more competitive as a just-in-time supplier.
Employee Involvement
A successful JIT environment can only be achieved with the cooperation and involvement of
everyone in the organization.
The concepts of elimination of waste and continuous improvement that are central to the JIT
philosophy can only be achieved through cooperation by people.
Instead of being the receivers of orders, the operators must take responsibility for improving
processes, controlling equipment, correcting deviations, and becoming vehicles for continuous
improvement.

Their jobs include not only direct labor but also a variety of traditionally indirect jobs such as
preventive maintenance, some setup, data recording, and problem solving.
One important aspect of JIT is that employees must become more flexible in the tasks that they
can perform.
Just as machinery must be flexible and capable of quick changeover, so must the people who run
them.
The role of management must change.
Traditionally management has been responsible for planning, organizing, and supervising
operations.
Many of their traditional duties are now performed by line workers.
In a JIT environment there is more emphasis placed on the leadership role.
Managers and supervisors must become coaches and trainers and develop the capability of
employees and provide coordination and leadership for improvements.
Traditionally staff has been responsible for such things as quality control, maintenance, and
record keeping.
Under JIT line workers perform many of these duties.
Staff responsibilities then become those of training and assisting line workers to perlorm the staff
duties assigned to them.
Manufacturing Planning and Control
No matter what planning and control system is used, the four basic questions have to be answered:
 What are we going to make?
 What do we need to make it?
 What do we have?
 What do we have to get?
The logic of these questions always applies whether we are going to make a Sunday dinner or a
modern jet aircraft.
Systems for planning and control vary.

A manufacturing planning and control system (manufacturing resource planning) has proved
effective in any manufacturing environment.
The complexity of the manufacturing process, the number of finished items, and parts, the levels
in the bill of material, and the lead times have made the planning and control problems either
simple or complex.
If anything can be done to simplify these factors, then the planning and control system will be
simpler.
In genera, the JIT philosophy simplifies these factors, thus making the planning and control
problems easier.
The discussion that follows will look at how the various parts of the manufacturing planning and
control system relate to a JIT environment.
In general, JIT manufacturing does not make obsolete the manufacturing planning and control
system but in some ways does change the focus.
Forecasting
The major effect that JIT has on forecasting is shortened lead time.
This does not affect forecasting for business planning or production planning but it does for
master production scheduling.
If lead times are short enough that production rates can be matched to sales rates, then forecasting
for the master production schedule becomes less important.
Production Planning
The JIT system emphasizes relationships with suppliers.
One purpose of production planning is to arrange for long-lead-time purchases.
The JIT process has the potential for reducing those lead times, but more important, it provides an
environment in which the supplier and buyer can work together to plan the flow of material.
Master Production Scheduling
Some scheduling factors are affected by JIT.
Master scheduling tries to level capacity and JIT tries to level the schedule based on capacity and
material flow.
The shorter lead times reduce time fences and make the master production schedule more
responsive to customer demand.

The ideal lead time is so short that the company can respond to actual sales and not to forecast.
Where the company builds to a seasonal demand or to satisfy promotion, a forecast is still
necessary.
Planning horizons can also be reduced.
The JIT system requires a stable schedule to operate.
This principle is supported by the use of time fences.
These are established based on lead times and the commitment of materials and resources.
If lead times can be reduced through JIT practices, then the time fences can be reduced.
.
Traditionally weekly time buckets are used.
This has given manufacturing an organizational buffer to plan and organize actual work flow.
Because of reduced lead times and schedule stability, it is possible to use daily time buckets in a
JIT environment.
Material Requirements Planning
Material Requirements Planning (MRP) plans the material flow based on the bill of material, lead
times, and available inventory.
Just-in-time practices will modify this approach in a number of ways.
The MRP time buckets are usually I week. As lead times are reduced and the flow of material
improved, these can be reduced to daily buckets.
The MRP netting logic is based on generating order quantities based on the planned order
releases of the parent, the inventory on hand, and any order quantity logic that is used.
In a pure JIT environment there is no inventory on hand and the order quantity logic is to make
exactly what is needed.
Therefore, there is no netting required.
If the lead times are short enough, component production occurs in the same time bucket as the
gross requirement and no offsetting is required.
Bills of material can frequently be flattened in a JIT environment.
With the use of work cells and the elimination of many inventory transactions, some levels in
bills of material become unnecessary.

Both MRP and JIT are based on establishing a material flow.
In a repetitive manufacturing environment this is set by the model mix and the flow rate.
The product to be made is determined by the need of the following work station, which is
ultimately the assembly line.
However, many production situations do not lend themselves to level scheduling and the pull
system:
Some examples are as follows:
Where the demand pattern is unstable
Where custom engineering is required
Where quality is unpredictable
Where volumes are low and occur infrequently.
Capacity Management
Capacity planning's function is to determine the need for labor, equipment, and material in order
to meet the priority plans.
Leveling schedules make the job easier.
Capacity control focuses on adjusting capacity on a daily basis to meet demand.
Leveling should make this task easier, but so will the JIT emphasis on cutting out waste and
problems causing ineffective capacity use.
Linearity, the practice of scheduling extra capacity, will improve the ability to meet priority
schedules.
Inventory Management
The JIT system will reduce the inventory in the system, and in some respects this should make
inventory management easier.
However, if order quantities are reduced and annual demand remains the same, more work orders
and more paperwork must be tracked and more transactions recorded.
The problem then is to reduce the number of transactions that have to be recorded.
One system that is used is called ―back flushing,‖ or post deduct.

Material flows from raw material to work in process to finished goods.
In a post deduct system raw materials are recorded into work in process.
When work is completed and becomes finished goods, the work-in-process inventory is relieved
by multiplying the number of units completed by the number of parts in the bill of material.
The system works if the bills of material are accurate and if the manufacturing lead times are
short.
Summary
The just-in-time philosophy and techniques that seek the elimination of waste and continuous
improvement were developed for repetitive manufacturing and are perhaps most applicable there.
However, many of the basic concepts are appropriate to any form of manufacturing organization.
In intermittent manufacturing material is processed at intervals in lots or batches and not

continuously.
It is characterized by large variation in product design, process requirements, and order quantities.
In the extreme every job is made to customer specification and there is no commonality in design.
Commonality exists in the processes that are used.
A contract machine shop is an example.
However, many companies make a variety of standard products in small volumes that are
manufactured either to stock or to customers order.
Many of these have families of products, and if these can be identified, then work cells can be set
up.
No matter what the characteristics of the intermittent shop, there are several JIT principles that
can be applied:
 Employee involvement
 Workplace layout
 Total quality control
 Total preventive maintenance
 Setup time reduction
 Supplier relations
 Inventory reduction

The JIT manufacturing environment requires a planning and control system.
The manufacturing resource planning system is complementary to JIT manufacturing.
The way that some of the functions are used change to reflect the differences in the manufacturing
environment, but overall the functions performed in the MRP2 system are those that have to be
performed in a JIT planning and control system.

Handling Obsolete Equipment/Materials, Surplus Equipment/Materials, and Scrap.
(Organizing and Controlling the Storage/Disposal of Hazardous/Regulated Materials)
Investment Recovery
The Role of the Materials Management and the Purchasing and Supply Departments
Why is investment recovery and surplus disposal assigned to purchasing? Usually no other
department in the firm is as well qualified to perform the task. The professional and managerial
skills required for a successful disposal operation are also required to do a good job of buying.
No other department of a firm is as concerned with or as informed about materials, their markets,
and related operating practices as the purchasing department.
The purchasing department routinely buys a large variety of raw materials, component parts, and
equipment. It has knowledge about who makes these materials, what other firms use them, how
they are used in its own firm, and how much they cost. This is the precise knowledge needed to
sell surpluses of these materials successfully. Also, a relatively large number of buyers in the
metal industries regularly buy some form of scrap or other surplus materials for their own
manufacturing purposes.
Disposing of Surplus Profitably
When material is declared surplus, the materials management, purchasing, or investment recovery
unit, as appropriate, is informed. Following this action, disposal is made by one of seven
methods:
1. Use within the firm.

2. Return to the supplier.
3. Direct sale to another firm.
4. Sale to a dealer or broker
5. Sale to employees.
6. Donations to educational institutions.
7. Some combination of the preceding methods.
Buying Surplus Material
Purchasing departments not only sell surplus material; at times they also buy it. Purchasing
managers often can find real bargains by shopping among surplus dealers. These dealers can
supply almost anything—from transistors to molding machines.
Managing and Disposing of Hazardous Materials (Potential Courses of Action)
The most effective action is to reduce or eliminate the generation of hazardous waste in the first
place.
Recycling and reusing certain materials often reduces the volume of objectionable materials.
Cleaning chemicals to remove hazardous contaminants is another approach used rather widely.

Yet another approach to “cleanse” a chemical is to use it in a chemically reactive process that
will neutralize it.
Basically, two approaches can be used in disposing of hazardous materials, along with the
packaging or containers in which some of the materials were originally shipped.
1. Purchasing may outsource the entire operation to a specialized contractor or consulting firm in
this business. This includes any laboratory testing required to shipment, packaging,
transportation, contracting with a hazardous material disposal site, and record keeping and
administrative requirements.
2. Purchasing may work directly with a transporter licensed by the Department of Transportation
(or federal and state EPAs) to haul the hazardous material --- and handle the other functions itself.
Or, of course, it can handle only a part of the other functions and subcontract some along with the
transportation activity.
At the disposal sites, most of the materials are incinerated. Other methods include
―encapsulation‖ and use of other methods of destruction, either chemical or physical.
Purchasing and the Environment
Key Environmental Laws
Lack of knowledge of specific environmental laws does not insulate purchasers and their
companies from potential criminal liability for violations. Although federal environmental law
specifies that a company must "knowingly" violate a provision, proving your company's
innocence can be expensive and time consuming.
Clean Air Act (CAA)

A comprehensive and complex law empowering the EPA to set national air quality standards and
delegate its enforcement to individual states to abate air pollution. Major provisions of the CAA
most likely to affect purchasers include the: (1) acid rain provision requiring U.S. coal-burning
power plants to reduce sulfur dioxide emissions by 50 percent by the year 2000, (2) toxic
emissions provision requiring a 90 percent reduction in the emission of 189 chemicals, (3) ozone-
depleting chemicals (ODC) provision to eventually eliminate the production and use of
chlorofluorocarbons, halons, carbon tetrachloride, and other ODCs, and (4) mobile emissions
provision requiring a 90 percent reduction of emissions of
pollutants from automobiles.
Toxic Substances Control Act (TSCA)

This act established a master database, the Toxic Substances Control Act Inventory List
(TSCAIL), of every chemical approved for use in the United States. Companies are not allowed
to manufacture or use any chemical not on this list. Every company must notify the EPA of any
chemical it uses or sells, and refrain from manufacturing or using any new chemical without
satisfying the TSCAÍs prenotification rules. Purchasers may want to require their suppliers to
warrant that any chemical or chemical mixture supplied is listed by the EPA on the TSCAIL.

Resource Conservation and Recovery Act (RCRA)
This act, which controls how hazardous chemicals are disposed of, broadly defines hazardous
waste to include almost every chemical. RCRA applies to every company that generates more
than approximately one-third of a 55-gallon drum of waste per month. Because the law assigns
"cradle-to-grave" responsibility to hazardous waste generators, purchasers contracting for waste
disposal may want to: (1) deal only with competent and reputable disposal suppliers that have all
necessary EPA permits, (2) require a supplier to warrant that all its employees are trained in
handling your company‘s type of waste, and (3) insist on the right to inspect the waste disposal
facility and its EPA permits.
Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA or

Superfund Act)
The company or companies that originally generated the waste often are held responsible for all
of the clean up costs for toxic waste sites, also called Superfund sites. CERCLA requires the
federal government to inventory all toxic waste sites, regardless of when they were created, set
priorities for their clean up, and implement site clean up.
Superfund Amendments and Reauthorization Act (SARA)

SARA deals with three aspects of toxic waste: clean ups; emergency response to massive spills
and other chemical emergencies; and the Emergency Planning and Community Right-to-Know
Act (EPCRA). The EPCRA section requires every plant that is using or storing substantial
amounts of dangerous chemicals to disclose that fact to the community. Purchasers may be
responsible for keeping track of the amount and types of chemicals that enter and leave the plant
and the material safety data sheets.
Hazardous Materials Transportation Uniform Safety Act (HMTUSA) HMTUSA

This act applies to shippers and carriers of hazardous materials, as well as those manufacturers
who fabricate and retest containers used for hazardous materials (hazmat). Purchasers‘
responsibilities under HMTUSA may include: (1)understanding and complying with the hazmat
labeling, packaging, handling, and documentation rules; (2) using only carriers with proper
hazmat safety permits; and (3) implementing a hazmat training program that meets Department of
Transportation requirements.
Total Cost Revisited: Don't Forget Disposal!
By considering the disposal variable within a total cost model, the issue becomes highly visible to
decision makers.
During decision making, embracing every cost issue of all affected operations can enhance
competitiveness. To often, when analyzing and optimizing the costs of one function or
department, other areas are sacrificed - and frequently to the overall detriment of the firm. To
overcome this, purchasers can involve the total cost concept which today includes the
environmental variable.

The Environmental Variable and Waste Management
The 1980s brought to the surface yet another total cost variable formerly left buried in the
financial "catch all" of corporate overhead. This environmental variable, created with the
enactment of the Resource
Conservation and Reclamation Act of 1976 (RCRA), assigned "cradle-to-grave" responsibility.
As a result, companies with disposal requirements must calculate the environmental cost of doing
business.
The disposal cost question became: "How can we legally dispose of our waste at minimal cost?"
Both internal and external reuse and recycling efforts increased, as well as the application of
waste treatment technologies to reduce both volume and offensive characteristics. The operative
cost variables of waste management follow.
 Basic haulage or "tipping" rates. This is the simplest item to measure.
 Development of new alternative relationships. Moving beyond the hauler, sourcing activities
include external waste treatment service companies, suppliers of treatment materials and
equipment, third-party contractors, and potential users of recycled or reclaimed materials.
 Internal handling. Waste becomes increasingly expensive when alternative disposal strategies
call for sorting and collecting activities.
 Process costs. Depending upon the outcome of the make or buy decision, these costs may
include acquiring the necessary technology and capital equipment for on-site treatment.
 Materials and supplies. If operating internally, a process will require additional materials such as
treatment chemicals, filter media, and MRO items ranging from spare parts to personal safety
supplies.
 Direct labor. Process equipment operators, but also additional materials handlers and
maintenance personnel.
 Management and supervision.
 Transportation. Shipment of processed materials to a potential outside user, or to and from a

treatment facility.
Waste Minimization
As successful as this total cost approach within waste management may be, the most successful
approach, albeit more cumbersome to implement, may be waste minimization. Here, the principal
assumption is that waste disposal costs are best addressed through the avoidance of waste
creation. Four generic approaches for eliminating waste at its source follow.

Different materials or supplies. Substitution of less hazardous; easier to collect, segregate or treat;
or have an alternative use or a ready market for recycling. As an example, more expensive
materials may be offset by improved yield factors and/or reduced disposal costs.
Different methods. Altering materials handling techniques, maintenance processes, waste
collection, and segregating procedures represent some of the "softer" solutions available. A use or
application variable, the segregating process, is frequently offset by substantially higher scrap
values. Initial segregation is far more cost effective than subsequently sorting co-mingled waste
streams. Improved inventory control can preclude creating obsolete product due to shelf life
expiration.
Changes to technology. Modifications may be made to existing process designs, equipment, and
the manner in which they interconnect including information collection and reporting on
performance. Real-time monitoring and control of operations can potentially avoid the
manufacture of off-spec product.
Redesign of final products. Recognition of total cost on a product-by-product basis reveals those
which may be marginally profitable because of escalating component waste disposal costs.
Product redesign and reformulation can potentially reduce these.
All cost elements outlined exist in all firms. Only recently, however, have their recognition and
appreciation of their interrelationships begun to emerge. As companies continue to divide their
operations into finer and more discreet business units, their ability to grasp the breadth of the total
cost concept - which includes the environmental variable - becomes simpler.
A Framework for Action
Starting with the waste generated material, options can be identified by following material flows
backward through the supply chain to their origins. This generic framework may be modified to
fit particular industry characteristics.
Assess residual outputs: quality and quantity, source or generation point, current disposal method,
cost or revenue from current method, hazards and liabilities, and compliance issues.
Assess product outputs: quality and quantity, packaging, inventory practices, shipping modes,
and customer characteristics.
Review processes: material and product flows, processes/equipment employed, bills of material,
raw materials and work-in-progress inventory practices, production throughput and scheduling,
and operating procedures.
Identify inputs: name of items and/or materials, suppliers, quantities, prices, delivery modes,
handling, and storage practices.
Develop possible options: substitute materials, other suppliers, potential for supplier returns,
improved procedures, salability of waste streams including off-spec products and materials,
potential for sales to existing customers.

Review impacts of options: waste stream quantities, product offerings, processes employed,
materials and components procured, operating procedures, and benefits. The benefits can include
costs avoided, revenues generated, energy recovered, and equivalent market value when used
internally.

Disposing of Hazardous Waste
Contracting with a waste-removal service mandates exceptional negotiation skills. The traditional
low-quote process must be balanced with other considerations. One of the most overlooked
aspects of the purchasing process has always been material disposal. Unwanted, surplus, excess,
waste, or scrap equipment and materials suffer from the "out-of-sight, out-of-mind" syndrome.
When the materials turn out to be dangerous or hazardous to people or the environment, the task
suddenly takes on critical importance. "Out of sight, out of mind" just might put you out of
business.
To date, there is no legally sound, court-tested method of transferring risk or responsibility to a

third party. Most laws are based on the "cradle-to-the-grave" concept. The initial user is
responsible for damage, loss, injury, or contamination caused by a particular hazardous substance
from the time it is originally shipped to the user until the substance is destroyed or degrades to the
point where it no longer poses a hazard. Some substances take thousands of years to decay into a
harmless substance.
The original manufacturer's responsibility is to use due caution in the manufacture and shipment,
to train and protect its own employees, and to provide the user with a material safety data sheet
(MSDS) along with the shipment.
Had the initial user not ordered the material, the manufacturer would not have created the
material in the first place. How that initial user handles, uses, transports, stores, and eventually
disposes of the material is beyond the manufacturer's control. These arguments will usually
prevail in court.
Purchasing's responsibility is to dispose of these materials legally while protecting the interests
and mitigating the risk of the owning entity. There are some substantial penalties for improperly
disposing of hazardous wastes. Lawsuits for injury, or damage to public or private property, can
be expensive to defend, even if you are innocent.
Strategies
Several strategies have been developed to help deal with these problems. Implementing any one
of these strategies can be much less expensive and time consuming than disposal, fines, or
litigation.
Redesign the end product to eliminate the use of hazardous materials in the manufacturing
process. This strategy is the best course of action to take whenever possible. However, many
manufacturing processes cannot occur without the utilization of hazardous materials.
Substitute hazardous materials used in the production process for nonhazardous materials. Newly
developed, synthetic, nonhazardous materials may be available for use. "Greening" your
production can be much less costly than disposing of hazardous waste. Remember to subtract the
cost of disposal from the usually higher procurement costs of synthetics.

Consume the hazardous materials. If you can consume all of your hazardous materials, then you
eliminate the disposal problem. Be careful, however, that you don't create a new hazardous
substance that must be addressed.

Recycle unconsumed hazardous materials. Many companies have found that leftover or
unconsumed hazardous materials are still usable in some form. Some materials are more useful in
their recycled state. Utilization of these materials can reduce the amount of hazardous materials
being purchased, reduce production costs, and decrease transportation, storage, and disposal costs.
Trade or sell the waste to other consumers. Another company might even be willing to pay you
for the right to use unused, surplus, or recycled materials. Be very careful here. You are dealing in
leftover, undepleted hazardous materials. While it is legal to sell the material, you will not be
relieved from your responsibility. The best you can do is to write indemnification and insert
harmless clauses into the sales contract, and hold your breath. You should remove any company
identification from any materials leaving your site, and you must supply material safety data
sheets to the new owner. Be sure to consult your attorney on title transfer.
Neutralize or detoxify the waste. This is an excellent strategy, if you have the opportunity and
capability. If you are fortunate enough to be using a substance that is easily detoxified, you are in
luck. Many substances require extensive treatment, autoclave, or high-temperature incineration,
to neutralize. Additionally, obtaining permits and certificates from local governments to operate a
system can be an insurmountable challenge.
Contracting
Contracting for hazardous-waste disposal calls for a negotiated agreement with a reputable
company. Traditional low-bid-process solicitation and competition should not be used. The risks
are simply too great. There are several steps that can be taken to ensure an effective selection
process.
Check local availability. Several waste-disposal companies are represented in most major
metropolitan areas. The Yellow Pages of the closest major city is an excellent source. Other
sources include the local chamber of commerce and other organizations that require hazardous
waste-removal services.
Select two or three disposal companies that you feel might be best suited to dispose of your
particular classification of waste. Remember that there are different types of hazardous materials
(hospital infectious waste, chemical waste, nuclear waste). Find out which companies specialize
in your specific type of waste.
Check the disposal company's track record. This is no time to try out the rookie. Of course, this
type of action could be viewed as exclusionary. Your management must decide if the merits of
inclusion outweigh the risks.
Obtain and check references. Make sure that the clients that the disposal company has served are
satisfied with the services. Does the company have adequate insurance? Does the company use a
reliable form of transport? Were certificates of disposal properly prepared and delivered? Was the
disposal company cooperative in customizing an agreement to fit a specific situation?

Avoid signing the disposal company‘s standard disposal agreement. It is written in the best
interest of the disposal company, not the customer. Renegotiate the standard agreement to
minimize your risk.
The "cradle-to-the-grave" philosophy means that the original using organization can never be
totally released from responsibility as long as the material or substance is a threat to the public or
the environment. Therefore, the only recourse the purchaser has is to involve as many levels of
responsibility as possible. A shared responsibility is certainly better than assuming the whole load
alone. The objective is to try to get the disposal company to assume a portion of the risk. Of
course, the disposal companies will resist, creating a need for increased purchaser negotiating
skills. Below are some techniques that have been effective.
Techniques
Use indemnification clauses in contracts. Carefully crafted indemnification and hold-harmless

clauses can be lifesavers. Most disposal companies will not strenuously object to a fair clause.
They will object to assuming the entire risk. Indemnification clauses should be used to cover
losses caused by their actions while the materials are in their possession. Be sure to consult your
legal counsel in constructing an adequate clause, or amending an existing clause.
Ensure adequate insurance. Most disposal companies are required by law to be insured. Be sure to
obtain certificates of coverage before releasing materials to the disposal company. Only by
reviewing this certificate can you determine the level of protection and the terms of coverage the
disposal company has retained. If in doubt, call the insurance company representative listed on
the certificate. Finally, make sure that you have adequate insurance to cover any contingency. Of
course, insurance for hazardous materials is expensive – but so is litigation. Coverage rates are
usually substantially lower if you can show your underwriter that he/she will not be in the first
position in the event of a claim. Place the disposal company's insurance carrier in first position. In
the event of loss, damage, or injury after pick-up, it is preferable to have the disposal company's
or carrier's insurance company in first position. This simply means that you will be in line for
liability only after claims against the disposal company and carrier are exhausted. Discuss this
strategy with your attorney. The laws vary from state to state, and may affect your position.
Demand and retain certificates of destruction. The certificate of destruction is not a "get out of jail
free card" by any means, but is adequate assurance that the disposal occurred in the proper way.
Never dispose of a certificate of destruction. Damages caused by hazardous substances that can
be traced back to the original owner will incur liability even if the company is no longer in
business. Heirs, successors, and perhaps even new owners may be implicated. This certificate
should be retained as long as possible.
Properly identify the materials. Proper identification of the materials or substances being disposed
of is absolutely essential. Unidentified materials in the shipment may not be handled properly. If
you have not identified these materials to the disposal company or carrier, you may have avoided
your indemnification. Be sure that you have accurately identified each component that must be
destroyed.

While it is absolutely necessary to identify the materials to the disposal company and carrier,
identification of the owner is not required. Labels, tags, and markings on packages and
substances that identify you as the owner should be removed. Do not remove labels, tags, or
markings that identify the product. After the shipment leaves your location, no company
identification should remain on the substances whatsoever. Following these few tips can make a
big difference in your disposal operations. Consulting an attorney to protect your interests is
definitely recommended. Take every precaution to mitigate the risk to you and your company, and
you will find that you can dispose of hazardous materials legally, safely, and without self-
destructing.
Risks
If none of the above strategies for eliminating waste are suitable for your organization's needs,
your only option is to dispose of the material by using legal and safe methods. With disposal,
your risk increases dramatically.
Companies that illegally dispose of materials - in landfills, dumpsters, or sewer systems - if

detected, face severe civil and possibly criminal penalties.
Even companies that have legally contracted with waste-disposal companies face penalties when
the disposal firms act improperly.
Any accident, spillage, or contamination prior to destruction will place the original user in
jeopardy. The original user may still be liable for the contamination, even if the user was not at
fault for the accident.
Improperly trained employees of both the using organization and the waste-disposal company
may file suit for damages or loss due to injury or contamination.
Lack of proof of proper disposal can still place the using organization in a difficult position.
Hazardous Materials Packaging: To Protect and Comply
By making an unauthorized change to the packaging purchasers are likely to be subject to all the
liability of an unauthorized packaging manufacturer.
All domestic shippers of hazardous materials must comply with HM-181 for new packaging. The
standards affect products classified as hazardous by the Department of Transportation (DOT),
including flammable liquids and solids, oxidizers, poisons, corrosive materials, and various
miscellaneous hazards such as hazardous wastes. The rules may be found in title 49 of the Code
of Federal Regulations (CFR), parts 100-180. The primary significance of the new requirements
for purchasers is the obligation of the purchaser of hazardous materials packaging to correlate the
detailed characteristics of the intended contents with the packaging being purchased.
The regulatory system is based upon recommendations developed by the United Nations (UN)
Committee of Experts on the Transport of Dangerous Goods. One fundamental element of the
UN recommendations is the division of each type of hazardous material by degree of danger into

"packing groups." Packing Group I materials are those with the highest degree of hazard, for
example the most highly corrosive materials within the broad regulated class of corrosives.
Packing Group II materials pose medium danger, while Packing Group III materials pose the
lowest hazard of regulated material. Thus, all hazardous material shippers in the United States
must enter the proper packing group of the material being transported as part of their shipping
description.

Additional regulations require the shipper to purchase packaging from the manufacturer by
identifying the packing group of the intended contents, the specific gravity and vapor pressure of
liquids, and the gross mass of the material. With this information, the manufacturer of the box or
drum will then determine and perform the minimum required testing. For example, a drum for a
Packing Group I liquid must pass a six-foot drop test, whereas Packing Group II packaging needs
only to pass a four-foot drop test. Markings are applied to the packaging and a testing report must
be prepared and kept by the manufacturer to certify that the packaging meets the purchaser's
requirements.
The regulatory system is intended to provide more flexibility, but at first purchasers may find it
more cumbersome than the old DOT specification packaging system. In addition, purchasers will
have to take steps to assure compliance, such as:
1. Provide detailed information about the product to the packaging supplier.

2. Correlate the hazards of the product with the appropriate packaging, by telling the packaging
maker the minimum test levels the packaging must pass.
3. Consider modest changes in packaging to minimize testing, retesting, and additional costs
related to testing.
4. Ensure the packaging maker sends a written statement describing the capabilities for the
packaging, as confirmed by its testing, and the necessary steps the filler must take to assure
closure is completed in the same fashion as the tested design.
By not following these steps during packaging filling and closure, purchasing organizations may
void the responsibility of the packaging manufacturer. In addition, by making an unauthorized
change to the packaging, purchasers in effect create a new design and, unless that new design has
been tested, purchasers are likely to be subject to all the liability of an unauthorized packaging
manufacturer.
DOT may make some minor adjustments to the regulations, but no major changes are expected,
nor in compliance dates. Therefore, hazardous materials shippers should move forward now not
only to assure compliance by the deadline but implement routine training and operational
procedures to achieve compliance efficiently.
GreenSpeak
"Green" purchasing requires purchasers and suppliers to work together as a team.
Over the months, our hotels have made great strides in substituting products manufactured and
packaged from non-environmentally responsible to those more proactive to this concern.
As a supplier and an important element to this critical issue, we ask that you take careful note of
our Environmental Purchasing Specifications attached, appreciating that environmental merit of a
product will be weighed equally with price, quality, and availability in the purchasing decision.
While "perfectly green" products may not be achievable in all aspects, it is our aim that each and
every purchase have the least negative impact on the environment.

Preferential treatment may be offered to companies which actively source and offer ecologically
sensitive product lines, are responsive to our requests, and practice good environmental
stewardship. Conversely, hotels reserve the right to reduce the size of orders given to, or
eliminate from the bidding process entirely, any company which fails to address these concerns.
Claims such as "Green," "Biodegradable," "Natural," and "Recycled" need to be substantiated

with the initial bid.
Defining Green
What is "green" purchasing? It's part of environmentally conscious management, which can be
defined as a system that integrates product and process design issues with the issues of
manufacturing production planning and control and supply chain management. Green purchasing
identifies, quantifies, assesses, and manages the flow of environmental waste with the goal of
reducing and ultimately minimizing its impact on the environment while also trying to manage
resource efficiency.. A different and new image of "green" purchasing has emerged - one which is
cost- and strategy-driven, economically justified, and integrated with corporate and product/
process decisions.
Getting the Facts
Even in cases when the supplier has refused to provide information on the grounds that the
material composition is proprietary, the purchasing company will refuse to introduce the new
material into the plant until its environmental effects are fully known. The supplier will simply
not be allowed to do business with the company under these conditions! In this regard, the plant
environmental engineer plays a key role as a liaison and information support person to aid
purchasing and plant employees who are encountering potentially hazardous environmental
situations.
Finding the “Greenest” Suppliers
A key element of evaluation involves understanding and assessing the environmental risk
associated with the particular chemical being purchased. Ask the following questions about
your suppliers:
Are their costs out of line, signifying that they have had to pay environmental cleanup fines in the
past?
Is the supplier in danger of being shut down by the government because of environmental
violations?
Are they a healthy company, and what is their employee exposure and safety records?
Supplier selection is also important when raw materials are being purchased for the research
function. The specifications for the item often originate from the business strategy -- purchasing's
role is to assess available sources of supply and provide a supply strategy. One criterion of this
strategy is to evaluate the supplier's capabilities regarding distribution, safety, incidents, health
records, and adherence to Responsible Care. Generally, only suppliers who are signatories to
Responsible Care will be considered. If not, they are viewed on an exception basis - will the

supplier subscribe in the future? Other questions address who moves the product. Dow specifies
sources and routings and they rely on the supplier to comply. The supplier will be allowed to
move the product if they are considered safe. Otherwise, Dow has their own group of contract
carriers to carry out this function. To sum it up, price is not the only factor to consider if
purchasing is dealing with a hazardous material. The cost of litigation and cleanup of a spill or
accident will far surpass the pennies saved per pound of material.
Purchasers can expect green purchasing to become a fact of life. The only way for many
purchasers to make the most of this new development is to understand what is involved in and the
reasons for the movement to green purchasing. Green purchasing is a misnomer - the green
referred to is not environmental waste reduction but rather increased profits.
Guidelines for Going Green
Managers recognize that purchasing green is not only good for the environment but also very
healthy for the bottom-line. To purchase green, purchasers and suppliers must actively work as a
team - not as adversaries - to draw on each other's skills and knowledge. The following guidelines
can help purchasers and suppliers work together toward fulfilling environmental goals:
 Have clear, feasible objectives for your organization and for your suppliers that can be measured
and captured in quantitative, meaningful terms.
 Measure green purchasing and supplier performance using well-understood, quantitative

measures.
 Communicate all successes internally and also with your suppliers through e-mail, newsletters,
and periodic meetings.
 Expect that both sides will make mistakes but learn from them.
 Be consistent with your suppliers in your pursuit of green purchasing.
 Try to link green purchasing with the four strategic dimensions of supplier performance: cost,
quality, lead-times, and flexibility.
 Emphasize teamwork and team building structures that bring together suppliers, manufacturing,
design engineers, marketing, and purchasing.
 Recognize the importance of design in terms of the effective achievement of green purchasing
objectives.
 Recognize the breadth of opportunities for green purchasing; that is, green purchasing can be
achieved by relying on options such as reducing waste, recycling, remanufacturing, prolonging
use of the product, reducing the environmental costs created by the use of the product, rebuilding,
reverse marketing (creating demand for the waste or pollution), and substitution.
 Don't ask your supplier to do anything that you and your organization are not willing to do.

 Do not, if possible, solely market green purchasing as a "green" activity since this is a kiss of
death in many firms; rather, market green purchasing as cost- or quality-driven and measured.
 Keep in mind that buy-in from management of both your organization and the supplier's is
essential to making the program work.

One Purchaser's Trash is Another's Treasure
Responsible for eliminating your company's waste? Find out if another company sees it as a
valuable product. Or maybe you want someone else's trash. Materials exchanges help you sift
through the goods.
Materials exchange catalogs, available through any waste exchange agency (see below), offer
everything from fish and horse waste, sludge, and worm soil to wood pallets, plastic recording
tape cases, scrap rubber, and formaldehyde.
Waste diversion is becoming big business today. And purchasers and materials managers wanting
to save money and conserve the environment may find a "buyers' haven" in today's waste
exchanges. Nearly 30 waste exchange agencies throughout the United States help business and
industry make a
profit and save the environment.
Actual costs to participate in materials exchanges vary. The most common fee levied by a
materials exchange is a catalog subscription fee, typically $50 per year. The main costs to
purchasers and materials managers may be delivery costs for the company acquiring someone
else's waste.
A materials exchange program offers businesses a communications medium, usually a periodic

catalog in paper and/or electronic format, to advertise materials that would otherwise be destined
for traditional disposal facilities such as landfills.
A proposed strategy for getting the most out of the materials exchange concept.
1. Begin to see your business and the materials exchange catalog through new eyes. Turning trash
into treasure requires a new perspective. You can't do something new with an old way of thinking.
Like the proverbial optimist who sees the good in everyone, you must begin to see potential
reuses and recycling opportunities in everything.
2. Study the catalog. This isn't necessary every time, but as a get-acquainted exercise, it's a must.
The main tool of the materials exchange agency is the catalog. Investigate how the materials
exchange in your area is organized and who is participating. Get a feel for the materials categories,
the areas where most things are available, and how items advertised now may meet your needs.
(If an exchange agency does not exist in your area, consider starting one.)
3. Look for a match. Check the "materials available" section of the catalog. Are items of interest
advertised? If so, call the contacts listed and start shopping. If you have items you're ready to part
with, check "materials wanted." If there's a match, make calls to any potential new owners.
4. Write an ad. If you don't see what you want or need (to recycle) in the catalog, there's no better
way to learn than leaping in. The only way to know if someone will be interested in what you
have is to list it and see what happens. Once you have placed a listing, you are a player.
5. Call the coordinator. If you aren't a big risk taker, even in the reuse and recycling want ads, call
the materials exchange coordinator. He or she can tell you stories about matches that have
occurred through the catalog or computer network. These anecdotes are always inspirational.
Maybe what you have to offer is exactly what the last caller was requesting.

6. Be an avid catalog reader. Always take at least a quick look to be up on what's happening or
may have changed in the trend of the materials being exchanged.

7. Talk about the materials exchange concept with others. Materials exchange programs often
connect totally unrelated businesses to network them for mutual benefit. What's not to like? Tell
your friends, because the more the word goes out the grapevine, the more participants, materials,
and great opportunities for trade.
Brag about being a "green" business. As a materials exchange user, you have every right. In your
literature, when you state what your company is doing for the environment, list your participation
in the exchange right up there with office recycling and purchasing recycled products.
Be creative. If you've done all these things, a whole new world of potential reuse and recycling
has been opened up to you.
The sky's the limit. People have developed entire new product lines out of discarded material
from another business. What hidden treasure will you find?
A computerized, national network may make finding your treasure among the trash simple.
Sponsored by the U.S. Environmental Protection Agency, Pacific Materials Exchange developed
the not-for-profit National Materials Exchange Network that electronically links nearly every
industrial waste exchange in North America. With a computer and modem, you can call toll free
in the United States, 800/858-6625 (Canada 509/325-1724), which connects you to the network
listing more than 5,000 materials available and materials needed, including waste by-product, off-
spec, overstock, obsolete, and damaged materials; used and virgin, solid and hazardous. Up to
now, waste exchanges have relied on print materials to advertise waste streams; and the efforts by
individual waste exchanges were generally concentrated in a limited geographic area.

PART II MRP, MRPII, JIT, ERP AND CRMSRM
MRP
INTRODUCTION
MRP systems have been around for a long time, and we have all heard stories about companies
whose MRP implementations were not as successful as those companies had hoped they would
be. There are, we think, two underlying causes for this problem. One is that we tend to look at the
MRP as a complex computer system that will answer all of our needs (or most of them). The
second is that people tend to become slaves of the system, trying to feed it the "right" information
in an attempt to analyze the mountains of data that the system generates.
What is happening in the companies that successfully use an MRP system is that the people have
learned to use the system as an effective tool. This is done by people just like you and me looking
at the underlying process flow in our business organizations. There are two basic actions that we
need to examine. We must reduce the lead time that is required to take our product through the
process, and we must simplify that process as much as we possibly can. We are going to examine
a couple of companies that have done these two things very successfully, with the outcome that
both companies improved their schedule adherence. Their processes were simplified to the point
that they could produce their products very quickly, making their schedules so dependable that
there was marked improvement in customer satisfaction. Of course, one of the chief objectives of
any MRP implementation should be enhanced customer satisfaction.
REDUCE LEAD TIMES

There is an old saying that tells us that no matter how short our lead time is today, it should be
shorter. Lead time is not a fixed, scientifically-derived quantity. Rather, it is a variable number,
and it depends a great deal upon how our people manage it. Lead time is a function of the priority
and the queue, or wait time. Both of these can be minimized by keeping the queues short and
having the smallest possible amount of product on the shop floor at a given time. To do this with
an MRP system, we should have short planned lead times and release our paperwork at the last
possible moment. The information listed as "planned order releases" is used to tell us what future
actions are needed without actually releasing the orders to work in process.
We must look at ways to increase our throughput rate on each of our shop operations by reducing
setups, organizing the workplace, and other techniques such as preventive maintenance to
optimize machine usage. Teams of our people should be working on set-up reduction, material
movement efficiency, and building quality into the product (as opposed to scheduling inspection
time).
One other method of reducing queues and reducing throughput time in the shop is to look at
processes from the viewpoint of synchronizing our operations, combining like operations into
functional groupings, such as a U-cell or a flow line. We should look at the processes from the
point of view of the product as opposed to a functional layout. Rather than becoming more
sophisticated with our MRP calculations of capacity loads or the accuracy of our capacity
planning logic, we materials professionals must focus on keeping our lead times short and the
work-in-process queues small.

One of the best examples of this is a major manufacturer of orthopedic implants --"spare parts"
for the human body, such as hips, knees, and bones. Several of these items are single component
products that are the best example of the combination of operations into a flow line to reduce lead
time. When the company had a functional plant layout, parts of one product family took ninety
days of shop lead time. The reason for this was that the work centers were spread out to such an
extent that the average product travelled more than nine miles. This situation meant that at any
given time, there were more than 20,000 pieces in the various stages of work-in-process. Not only
did it take a long time to get the product through, it was likely that sometime during that time,
priorities for a particular order were likely to change. This caused an enormous amount of
schedule changing, and the resulting scurrying around that we know as expediting. Attempts to
reduce the expediting by creating an increasingly sophisticated MRP system had only marginal
results. A quantum leap occurred when the company looked at the manufacturing process and
consolidated the work centers into a Just-in-Time flow line. Now, the products only travel about
100 yards down the line, with something less than 2,000 pieces of work-in-process. Concurrent
with the consolidation effort they also focussed attention on the organization of each work center,
and worked to reduce set-ups. The planned lead time, as a result, was cut to fifteen days. Instead
of focussing the MRP system on the dynamics of work-in-process, the people now concentrate on
getting the signals out to vendors to match the flow rate of production. The people who work with
the MRP system are concerned more with the aggregate output demand rate than with the
dynamic priority updating inherent in most MRP systems. This all happens because the lead time
is short and the queue is small.
SIMPLIFY THE PROCESS

The next step on the journey to improved schedule adherence is to simplify the MRP process to
match our simplified shop process. There are several techniques that can be employed to reduce
the amount of paperwork generated by the MRP system and the resulting transactions needed to
keep it up to date. If we have reduced our process to a flow line, we might want to schedule all of
our components as inputs to the flow line, with any intermediate subassemblies taken out of the
MRP logic altogether. We can now release only one work order to make a completed assembly.
This is known as "flattening the bill". A companion concept is known as backflushing. This
consists of setting up an assembly line where the components are stored at the line itself, readily
available to the operators for whatever assembly they are making at the time. Rather than process
transactions for each component for each order, parts are issued from the stockroom to the
assembly area in large quantities. At the end of the line, we process transactions showing the
quantity of assemblies produced. By looking up the bill of material in the MRP system, we
determine what components must have been used to build these assemblies. We can then subtract
that usage from the quantity which was issued and stored at the work-in-process location. Of
course, we must focus our attention on the accuracy of our bill of material so that the bill as it
resides in the computer matches exactly with the way the shop puts the parts together. only under
this condition will backflushing be effective.
The main advantage of this technique is that we have minimized the number of transactions and
work orders processed through our MRP system. Many companies create huge numbers of work
orders and transactions because the MRP system "requires" it, and the company gets bogged
down in paperwork. By flattening the bill and using the computer to calculate the quantity of parts
that must have been used, much of this needless detail is eliminated. Therefore, we should focus
our efforts on the flow of parts, not on the MRP level-by-level processing.

One of the best examples of this process that we know about is a major manufacturer of material
handling equipment. They manufacture belt conveyor systems that utilize rollers to support the
belt while the material flows along it. These rollers are made of steel tubes with appropriate
bearings, grease seals, and nuts. They are manufactured on an assembly line that stretches the full
length of the plant. The components are delivered to work-in-process locations at the various
assembly points along the line. Transactions are used to transfer inventory from stores locations
to these work-in-process locations. At the end of the day (or the end of the order, whichever
comes first), the credit transaction is generated for the assemblies produced, crediting the
assemblies into finished goods. The MRP backflushes to issue the components from the work-in-
process locations. This is done even for the raw material steel tubing, which arrives at the cutting
machines in full bundle quantities. This simplification of the process caused their MRP
scheduling system to create only one work order for any particular size of roller. There were no
orders for individual pieces, although the engineering bill of material called for individual
subcomponents.
This resulted in a drastic reduction in the number of work orders and transactions that needed to
be processed through the MRP, allowing the people to focus their efforts on supplying products
and components to satisfy customers. This is a far better use of time than shuffling paper to
appease the MRP system.
A companion process is known as modularizing the bill of material. This is usually employed
when a product can be sold with a number of different configurations or options, such as an
automobile. Rather than stocking every possible permutation and combination of assembled
automobile, it makes more sense to master schedule major components and subassemblies. One
of the better examples we know of for this is a major manufacturer of hydraulic motors. They
make six different types of motors, but within each type there are virtually an infinite
combination of shaft, rotor, housing, and other configurations. As they focussed on the flow of
parts within their manufacturing process, they decided to stock just the major components, master
scheduling them using the MRP system. When a customer orders a specific configuration, they
create one final assembly order, a flat bill of material one level deep that processes the
components down the assembly line. Component parts are issued by backflushing the customer
order. By using these techniques, this company can effectively manage the total flow of work in
the plant using six modular bills of material. This again simplifies the MRP process to allow the
people to focus on the flow of parts and not the cumbersome transactions of the computer.
SCHEDULE ADHERENCE
There are thousand of things we can do to improve on the MRP system, but we know that the two
steps of reducing lead time and simplifying process both yield improvement in schedule
adherence. Schedule adherence is one thing that must be achieved in order to satisfy our
customers. With MRP systems, we tend to focus on making the due date match the need date as
priorities change. This is an important requirement in the maintenance of a valid priority
management system. But when we can reduce the lead times and simplify the process to the point
where orders are produced very quickly, we can drastically reduce the number of schedule
changes required by the dynamics of the marketplace. We find that companies tend to become
more reliable in their production when using very short schedules.

This means, simply, that we have the assurance when we start an assembly down one of our
assembly lines that we can depend on when that assembly will be completed. Figure 5
emphasizes that we must motivate all our people toward dependable schedule adherence. Once
we have this mindset established throughout every level of our company, we can see significant
improvement in customer satisfaction -- with both the internal and the external customer.
The conveyer manufacturer is one good example of this mindset that we can identify. Every
member of the organization knows that their final assembly schedule for their configured roller-
and-frame assemblies will be shipped within four hours of order entry. The production process is
set up to support this speed, the planning process is set up to support it, and the familiar name for
one of these four-hour orders is a "green" order, indicating that the green light is on for it to flow
through the shop unimpeded. They could do this because their process was simplified by
flattening the bill of material, minimizing the paperwork, and focussing on quick throughput at
the assembly operations.
Our orthopedic manufacturer, on the other hand, communicates very effectively how well we
adhere to our schedules for all work orders travelling down the Just-in-Time line. This is done by
time-stamping each order on its entry into the work line and logging its completion time. A
member of the team then goes to the big whiteboard at the head of the production line and records
the lead time it took. The data is plotted on a very prominent graph, communicating to the entire
world how well we're doing. (See Figure 6] This graph has become the focal point of the team's
ownership of the objective to reduce lead time to meet or beat the plan. Right now, they are
discussing the reduction of the planned lead time to under ten days.
CONCLUSION
We can see from these examples that the real key to a successful MRP system is that the people
look at the process of delivering the product to the customer. We focus on simplifying the process
and reducing the amount of time that it takes for the product to move through our operations.
Then we can look at the MRP paperwork system and streamline it to match.
Real progress is made when people can use the MRP tool more effectively, and that can be done
by looking at our processes and instituting improvements like the ones we have described here.
Think about what you can do to apply the techniques that will work in your own business to
reduce lead time, shorten the process, and improve your schedule adherence.
Just-In-Time (JIT)
Abstract. Both practitioner-oriented and academic literature suggest that just-in-time (JIT)
purchasing as a management innovation can be adopted by organizations as a strategy to gain
advantage over their competitors. Seven characteristics of JIT purchasing are identified based on
a comprehensive literature review. These elements are supplier cooperation, materials quality,
quantities purchased, transportation, top management support, training and employee relations. A
review of benefits of JIT purchasing implies that implementation of JIT purchasing can increase
firms' performance. The benefits include higher inventory turnover, increased product quality and
productivity, which theoretically lead to a reduction in product costs. High product quality and
reduced costs will usually result in lower prices. Lower prices will lead to increased market share
and profit. Data have been collected by a mail survey from both large and small manufacturing
and service organizations. The subjects of the survey are business unit chief officers or high-

ranking managers. The firms and subjects are identified through a literature review, and the
rosters were provided for this research by the American Society for Quality Control and the
National Association of Purchasing Management. The research results are presented and
discussed.

Introduction. In the late 1970s and early 1980s, previously unchallenged American industries lost
substantial market share in both U.S. and world markets. To regain the competitive edge many
companies have impetuously launched into productivity improvement programs (Chase and
Aquilano 1992). One of these "so-called improvement programs" is just-in-time purchasing
(JITP).
However, implications of JIT on strategic performance has not been explored in the literature.
Adam and Swamidass (1989) point out that "manufacturing strategy literature has not formally
embraced JIT for its strategic value to manufacturers" (p. 196). A study by A. S. Sohal, Ramsay,
and Samson (1993) shows that the link between JIT and competitive strategy is less common than
between JIT and operational tactics. The findings of their study reveal that only 17 percent of
firms perceive JIT as a strategic tool to increase competitiveness whereas 44 percent think JIT is
utilized to improve operations.
Studies by Ansari and Modarress (1987, 1990) show that companies having implemented JITP
estimated a 43 percent increase in product quality and a 21 percent improvement in productivity.
Given that approximately 50 percent of cost of goods sold consist of costs of materials, firms can
utilize JITP to improve their performance. Grounded on both the theory of innovation and the
relationship between innovation, strategy, and performance, this study attempts to explain the
strategic value of JITP as a management innovation in different types and sizes of organizations.
Furthermore, this research examines firm performance based on the theories from business
strategy, marketing and operations management. Thus, the purpose of this study is to fill a void in
the literature by identifying the effect of JIT purchasing on firms' performance in both large and
small manufacturing and service organizations.
Characteristics of JIT Purchasing. Characteristics of JIT purchasing can be broadly categorized
into two groups: external and internal. External characteristics require some changes in the way a
purchasing department approaches procurement activities. Internal characteristics are those
elements that require some organizational commitment.
External Characteristics of JIT Purchasing. External characteristics of JIT purchasing are
1. supplier cooperation,
2. purchased quantities,
3. materials quality and
4. transportation (Schonberger 1982; Schonberger and Gilbert 1983).
As Ansari and Modarress (1990) indicate, although purchasing activities are the same in both JIT
and traditional purchasing, they differ in approach. These external characteristics will be briefly
discussed as follows: 1. Supplier cooperation. In JIT purchasing, materials and parts are usually
bought from a single source, as opposed to purchasing from multiple sources under traditional
purchasing activities. Empirical studies consent that, with the implementation of JITP,
organizations have switched to fewer sources (Billesbach, Harrison, and Croom-Morgan 1991;
Dion, Blenkhorn, and Banting 1992a; Freeland 1991; O'Neal 1987).

Dealing with fewer suppliers for a particular item or items contributes to establishing a long-term,
stable and satisfactory relationship between a supplier and buyer (Ansari and Modarress 1990;
Schonberger 1982; Schonberger and Gilbert, 1983). In his study, O'Neal (1989) finds that almost
two-thirds of the suppliers have had long-term agreements with their customers.
Supplier evaluation is also different under JIT purchasing from evaluation under traditional
purchasing. JIT purchasing emphasizes supplier evaluation based on product quality, delivery
performance and price. Supplying defective items is not tolerated. In fact, Billesbach et al. (1991)
find that a majority of respondents have evaluated their suppliers based on delivery reliability and
quality conformance.
Under JIT purchasing, achieving product quality through a long-term contract at a fair price
receives the highest priority. The findings of a study reveal that both U.S. and U.K. companies
have placed high priority on quality and delivery in negotiation practices. However, they also
rated response flexibility and competitive price reasonably high (Billesbach et al. 1991).
In summary, in terms of suppliers, JIT purchasing differs from traditional purchasing in terms of
the number of suppliers, the selection and evaluation of suppliers, and the negotiating and bidding
process. Thus, suppliers have a considerable effect on the implementation of successful JIT
purchasing (Fawcett and Birou 1993).
2. Purchased quantities. In JIT organizations, products are produced in small lot sizes when
needed, and in turn, materials and parts are frequently delivered in small lots (Chapman and
Carter 1990). Furthermore, most importantly, lots must be delivered in exact quantities, neither
more nor less (Ansari and Modarress 1990; Freeland 1991; Lee and Ansari 1985; Schonberger
1982; Schonberger and Gilbert 1983; Willis and Huston 1990). Several empirical studies find
support for the increase in delivery frequency under JIT purchasing.
In his study, O'Neal (1987) finds that, under the JIT system, the average monthly frequency of
deliveries increases to 6.9 from 2.8 under traditional purchasing. The study by Dion, Banting,
Picard, and Blenkhorn (1992b) produces the following results pertaining to purchased quantities:
 200 percent increase in number of deliveries
 50 percent decrease in order lead times
 50 percent reduction in order size
3. Materials quality. When materials and parts are purchased in small lots and exact quantities,
clearly, their quality receives more importance since defective materials and parts cause
interruptions in production. Furthermore, the first step of producing quality products is the
utilization of the correct quality materials. As a result, supplied materials must have the correct
quality attributes (Grieco and Gozzo 1985; Hall 1983; Willis and Huston 1990). Counting and
inspection of received materials and parts are reduced or eliminated under JIT purchasing (Ansari
and Modarress 1990).

The findings of a study by Freeland (1991) indicate that the selection of both suppliers and
materials is based on quality. Also, the findings propose that good quality of materials is
necessary in order to implement JIT purchasing. In one study regarding JIT purchasing, 33
percent of buyers reported higher quality in JIT purchased parts (Dion et al. 1992b). The results of
the same study show the following changes related to purchased parts quality:
 40 percent decrease in damaged purchased materials
 20 percent decrease in buyer complaints about purchased materials
4. Transportation. Under JIT purchasing, agreements define delivery dates or times according to
the buyer's schedule, as opposed to shipping dates and times based on the supplier's schedule
under traditional purchasing (Ansari and Modarress 1990; Schonberger 1982; Schonberger and
Gilbert 1983). Furthermore, JIT purchasing involves both inbound and outbound freight, stressing
on-time delivery, whereas traditional purchasing emphasizes outbound freight, stressing low
freight cost (Ansari and Modarress 1990). O'Neal (1987) suggests that JIT purchasing requires
faster, more responsive modes of transportation than traditional purchasing because of frequent
deliveries in small lots. His study indicates that, under JIT, companies switched to motor freight
and private carriers from rail transportation and common carriers.
Internal Characteristics of JIT Purchasing
Some internal critical factors are required in the implementation of JIT purchasing, as well as in
the implementation of JIT production (Ahmed, Tunc, and Montagno 1991; Ansari 1986; Ansari
and Modarress 1986, 1990; Hay 1989, 1990a, 1990b, 1990c; Im and Lee 1989; Lee and
Ebrahimpour 1984). These essential elements include the following:
1. Top management commitment. Top management should make JIT purchasing a priority
for the whole organization and clearly communicate this commitment to the employees. The
necessary resources for the implementation of JIT purchasing should be provided by leaders.
Moreover, upper management should demonstrate leadership in order to provide positive
involvement of other functions (Ahmed et al. 1991; Ansari and Modarress 1986; Hay 1990a; Im
and Lee 1989; Lee and Ebrahimpour 1984). In their survey, Fawcett and Birou (1993) find that
companies which successfully implement JIT purchasing activities provide support at different
levels of management.
2. Training. Most importantly, purchasing people must be trained in the JIT philosophy.
Also, purchasing people should be trained in the necessary statistical tools, such as statistical
process control (SPC), in order to understand the variation in incoming materials. Furthermore,
training support in JIT purchasing and quality management should be provided to suppliers
(Ahmed et al. 1991; Ansari 1986; Ansari and Modarress 1986; Im and Lee 1989; Lee and
Ebrahimpour 1984). Utilizing teamwork from both parties in reducing the common causes of
variability in materials and parts can improve quality (Harrison and Voss 1990). In one study,
respondents report that the lack of training and education of suppliers has been a major
impediment in the implementation of JIT purchasing (Freeland 1991).
3. Teamwork. Acquisition teams should be established, which may include purchasing,
material control, process/design engineering and production representation. This interaction
provides the conditions necessary to solve supplier quality problems and facilitates

communication within the entire organization (Giunipero and Keiser 1987; Hall 1983). These
teams can be utilized in the selection of new suppliers (Burt 1989).
Strategic Value of JITP as a Management Innovation. Although there is a vast array of literature
on innovation, it is hard to find agreement on the definition of innovation. In this study, the
definition of innovation is the one adopted by Damanpour and Evan (1984): "the implementation
of an internally generated or a borrowed idea -- whether pertaining to a product, device, system,
process, policy, program, or service -- that was new to the organization at the time of adoption" (p.
393).
Schroeder, Scudder, and Elm (1989) discuss the effects of innovations assisting in the
achievement of significant improvements in organizations' cost, delivery and quality goals. In
their study, the researchers present a list of innovation definitions generated by managers. One of
these definitions includes changing the relationships with internal and external groups in order to
reach goals of the operation in the present and/or the future in a better way, such as supplier
relationships with JIT.
The literature on strategy types (e.g., Hofer and Schendel 1978; Miller and Roth 1994; Porter
1980; Richardson, Taylor, and Gordon 1985) reveals that the purpose of adopting specific
strategies is to increase market share and performance by either reducing costs or by
differentiating products. By adopting a JIT purchasing system as a strategy, firms can both reduce
their costs and differentiate their products. As discussed later, benefits of JIT purchasing indicate
that firms realize enhanced product quality and reduced costs as a result of the implementation of
JIT purchasing techniques (e.g., Ansari and Modarress 1990). O'Neal (1989) suggests that
automotive original equipment manufacturers' (OEM) final assemblers have served as the
innovators in developing and implementing JIT systems. With the JIT management system as a
major strategy element, the Automotive Industry Action Group played the role of a facilitator in
increasing the productivity of the industry.
Pearson and Gritzmacher (1990)suggest that the purchasing department can serve as a profit-
generating center rather than cost cutting mechanism. Purchasing costs consist of 50 percent or
more of a firm's total revenue in many manufacturing industries. With an increasing concern on
product quality in today's highly competitive environment, a company can gain competitive
advantage by utilizing the purchasing department's knowledge of supplier networks.
Implementation of the JIT concept brings such an opportunity to purchasing departments in firms.
According to a study by Dion et al. (1992a) although there is not any perceived increase in profit
from the products produced with JIT materials, 37 percent of firms reported an increase in their
sales as a result of JIT purchasing (Dion et al. 1992a). In their study, Fawcett and Birou (1993)
find that improvement in the overall competitive position of the firm was the most positive effect
of JIT purchasing.
The benefits of JIT purchasing can be classified into two groups: (1) direct and (2) indirect
(Ansari and Modarress 1987; Ansari and Modarress 1990; Gilbert 1990; Hahn, Pinto, and Bragg
1983; Manoochehri 1984; Schonberger 1982; Schonberger and Gilbert 1983). The most
important direct benefits include:
1. Increase in purchase material turnover,

2. Increase in ability to meet delivery promises,
3. Reduction in delivery lead time, and
4. Reduction in scrap cost.
The direct benefits of JIT purchasing lead to its indirect benefits. The most important indirect
benefits are:
1. Achievement in encouraging suppliers to meet quality requirements,
2. Improved product quality, and
3. Increased productivity.
Based on the literature review up to this point, the relationship between JITP and the performance
of firms are summarized in the research model as shown in Figure 1. Based on this model, we
suggest that the greater the extent to which companies implement JITP techniques, the higher is
the performance.
(Figure 1 is not available in this text-only version.)
The theoretical foundation of this study and previous research findings indicate that the effects of
JITP strategy on performance may differ across four moderating variables: Industry type, firm
size, firm type (the type of organization refers to service and manufacturing organizations) and
duration of JIT purchasing practices. The following paragraph provides some examples of the
effects of moderating variables.
Fawcett and Birou (1993) identify electronics, machinery, metals and transportation industries as
main users of JIT purchasing practices. Some studies document that JIT delivery is considered to
be a difficult element of JIT management to implement in small manufacturing firms because
these companies may have limited resources (Finch 1986; Finch and Cox 1986). Empirical
research in the implementation of JIT delivery in small firms reveals mixed results. Although, in
theory, JIT purchasing seems to be advantageous for small businesses and there is some evidence
of assistance from large buyers to small companies in its implementation (Sadhwani, Sarhan, and
Camp 1987), a survey conducted by Industry Week reveals that some of the small companies
complain of swallowing inventories to supply JIT companies (Sheridon 1989). Chase and
Aquilano (1992) stress the fact that, although service companies have not concentrated on
supplier cooperation for materials because the service costs mostly consist of labor, some service
companies such as fast food restaurants can benefit from implementing JIT purchasing. A study
by Freeland (1991) classifies organizations based on the benefits realized as 'High-JIT Purchasing
Benefits Organizations' and 'Low-JIT Benefits Organizations'. Further analysis reveals that 'High-
JIT Purchasing Benefits Organizations' had started to implement JIT in purchasing an average of
33 months before receiving the survey, whereas 'Low-JIT Purchasing Benefits' organizations had
begun to institute JIT purchasing, on average, only 24 months before. Freeland (1991) concludes
that "the longer JIT purchasing has been in place, the greater the reported overall benefits."
Research Design and Methodology: The research questions of this study lend themselves to cross-
sectional mail survey methodology on business units. Because this study examines the
relationship between JIT purchasing and firm performance, the target population was U.S. firms
which implement JITP techniques. The subjects of the survey are business unit chief officers or

managers, with such titles as president and executive vice president, because only these high-
ranking respondents would possess the three types of knowledge required for this study. The
firms and subjects were identified through a literature review, and the rosters provided to this
research by both the American Society for Quality Control (ASQC) and the National Association
Purchasing Management (NAPM). An instrument was developed based on an extensive literature
review and was pilot tested at a joint meeting of the NAPM and the American Production and
Inventory Control Society (APICS).
Target respondents received the questionnaires according to the Total Design Methodology
suggested by Dillman. The Total Design Methodology suggests a four-step procedure for mail
surveys to achieve a higher response rate. First, the questionnaire is sent to respondents with a
cover letter which describes the research project and its purpose, and assures the confidentiality of
the replies. The second step requires sending a postcard one week after the initial mailing as a
reminder to the nonrespondents. Three weeks after the initial mailing, a follow-up letter with
another copy of the questionnaire is sent to subjects who have not responded. Seven weeks after
the initial mailing, if a sufficient response rate has not been achieved, a second follow-up letter
with the questionnaire is sent to nonrespondents.
A questionnaire, including a cover letter and a postage-paid return envelope, was sent to 1884
subjects in the beginning of March, 1995. The breakdown of subjects according to membership is
as follows: 1180 ASQC members and 704 NAPM members. Due to the sufficient response rate
following the second and third steps of the Total Design Methodology, the fourth step was not
pursued. Some of the respondents who did not receive the initial questionnaire called to request a
copy of the questionnaire upon receiving the postcard. Depending upon their choice, a copy of the
questionnaire was mailed or faxed to them. A total of 382 survey replies were received, which
equals a 20.3% response rate. Of all respondents, 25.3% are ASQC members and 11.80% NAPM
members. Approximately 60% of the responses were received after the initial mailing and
postcards. To encourage response (Dillman 1978), it is made known that a copy of the aggregated
survey results, with a profile of the individual companies, is to be sent to the respondents at their
request at the end of the study.
MRPII For Planning JIT For Execution
The objective of this presentation is to demonstrate how successful companies are able to merge
MRPII and JIT. We shall look at several companies and how they plan and control materials and
capacities using both MRPII and JIT techniques.
Many people ask if Manufacturing Resource Planning (MRPII) and Just-In-Time can be married
together. We say they can by using MRPII for planning and JIT techniques for execution. Many
companies try to minimize their inventory investment by implementing an MRPII system. At the
same time these companies cultivate a philosophy of continuous improvement on the shop floor.
We think companies should extend the philosophy of continuous improvement into the planning
process also. We must make improvements to the process of planning what we are going to make,
what it takes to make it and what we already have. These are the three main inputs to MRP
planning: A master production schedule, bill of material and inventory status.
MRPII FOR PLANNING.

We are familiar with the normal issues surrounding an MRPII implementation. However, when
we focus on continuous improvement in the MRPII System we usually see a lot of work on the
shop floor execution system. MRP Logic is used to plan the flow of materials, particularity raw
materials to support the Master Production Schedule. Many companies establish a Master
Schedule and then use the MRP to explode that schedule into the requirements for material. Then
we use the requirements as a signal to suppliers for them to establish their Master Schedules.
However, the actual release of the materials to move from supplier to user is controlled by Just-
In-Time techniques.
FLATTEN BILLS OF MATERIAL.

In order for an MRPII System to work effectively with a JIT Execution System it is imperative
that we simplify the Bills of Material. Many companies say to KISS the bills: That is to keep it
short and simple. We should attempt to flatten the bill as much as possible, with one being the
ideal number of levels. We should reduce any intermediate levels out of our own manufacturing
bills. We can and should use techniques such as phantoms and backflushing to remove all sub
assemblies that exist inside our own plant. After all, we should question the purpose of any
intermediate levels, usually designed for efficiency of supply, and focus on the flow of parts to
support the end unit assemblies.
SHORTEN LEAD TIME.

The real enemy of any successful manufacturing company is time. The more time something
takes; the more complications are introduced and the more it costs. One company we know of
thought efficiency of supply would come from large orders going through functionally grouped
departments. One product traveled nine miles, took 90 days and had over 40,000 units of various
sizes in work-in-process. Their expectation was that a good scheduling system would eventually
keep track of all these orders and give them maximum customer service because "we always have
something in process". In reality, the MRPII Planning System becomes much more effective as
lead times get shorter. We can shorten lead time by focusing on the flow of product. Our
company with nine miles rearranged their work centers to get a product orientated flow that was
less than 100 yards. They also worked to reduce setups, which allowed them to lower lot sizes.
The combined effect of reduced lot sizes and more direct flow allowed them to reduce work-in-
progress queues down to less than 1/10 of what they were previously. All this had the effect of
reducing lead time to less than 15 days (from 90). That represents continuous improvement
combining the planning system with JIT execution.
MIXED MODEL MASTER SCHEDULING.

The intent of our planning system is to support a Master Production Schedule. Our planning
system will be most effective if we continuously improve by removing variation from the plan.
We can do that by utilizing the technique of mixed model master scheduling. That is to build
some of each item every day. See Figure 3. As you can see, this company plans to build some of
each item every day. They were able to accomplish this by simplifying their planning systems.
One item had fourteen steps in its routing. Even with bar code data entry they decided that was
too many operations to track and reduced it to one. Several layers of their Bill of Material are not
processed as an item in their MRPII System. Rather, the raw material is processed into
components and flows directly to assemblies out on the shop floor without processing
transactions through the planning system.

All of this works together to simplify the Bill of Material, shorten Lead times and reduce the
variation in the Master Schedules. We then effectively use the MRPII System to inform suppliers
about our planned flow of raw materials.

JIT FOR EXECUTION.
When we can get our Bills of Material flat enough and the production activity controls short
enough, then our own execution system becomes so short that it is insignificant compared to
purchased parts. One company we know makes components for computer monitors. As they say,
"continuous improvement is our production activity control system". Their total shop lead time is
less than five days but the monitor glass has a lead time of 10-12 weeks. It is not important to
plan and control our production with detailed dispatch plans, rather, first-in-first-out works fine.
We use MRPII only as a tool to communicate with our suppliers.
SUPPLIER PARTNERSHIPS.
We have all heard of supplier certification programs tied into quality programs focusing on
quality at the source. Many of these certification programs go on to discuss such things as blanket
orders with frequent deliveries. I maintain that industry shall continue to use MRPII planning
tools to establish the overall requirements with their suppliers. We may even work together
enough to reserve capacity with the supplier. Therefore, instead of ordering large blanket orders
for specific parts (with their inherent variability), let's reserve capacity based on our aggregate
volume using our production plan.
We would then set up a very responsive signal system to let our supplier know exactly what
quantity of what items are needed when. We know of some companies that use the telephone to
release orders for steel to be delivered from warehouses the next day. More sophisticated systems
such as visual signals (kanbans) and Electronic Data Interchange (EDI) can also be used as our
partnership seeks win-win solutions that are quicker and quicker.
CUSTOMER PARTNERSHIPS.
A companion idea to supplier partnerships is the same concept applied from the other direction:
customer partnerships. We are all customers of suppliers - and conversely a supplier to our
customer. Why not work with our customers just like we would like our suppliers to work with us?
Our objective is to work with our customer to remove fluctuations in the rate of demand. We
wish to take out variations in the demand for our products. Therefore, let's negotiate with our
customer and let them reserve capacity so that we can consistently meet their demands. We can
work together to define the beat at which he needs our product.
SYNCHRONIZED FLOW.
When we are armed with knowledge about our customer's requirements we can work together to
remove variations from the top level of our schedules. We can then look differently at how the
parts flow through our shop. We know of a company that used to make large batches of common
components used in multiple end units. Inventory grew and expediting got out of hand as
mismatched lots were being built to optimize efficiency. Their problems reduced significantly
when they focused on building all the parts that go into an assembly. They rearranged the shop
layout and paperwork system to build matched sets of components to meet assembly requirements.

SHOP FLOOR CONTROL BY SEQUENCE.
When we combine very short lead time with a flow of parts by assembled product, all sorts of
opportunities become visible. (Yes, the pun is intended) We know of several companies who
have gotten their lead times so short and the production process so predictable that first-in-first-
out is good enough production control. One company even releases orders in different colored
tote pans according to the day of the week: red on Monday, gray on Tuesday, green on
Wednesday etc. Therefore, everyone on the production line knows red tote orders should be
worked on before gray etc. This simplified method helps set the sequence of the flow of work.
FLEXIBLE CAPACITY.
When shop lead time gets very short, it is not profitable to focus on measuring workload, backlog,
efficiency, utilization and queue. Rather, we focus on what comes in must go out. The company
mentioned above with the various color totes can go out on the floor and see when they are falling
behind. The team can make decisions about how to get back up to the throughput rate: work over
time, add more people, stay late, etc. One company in Mississippi even goes so far as to have
college students they can call to come in and form a night shift crew when they need to flex
capacity. Federal Express calls in temporary workers each night at the hub in Memphis to make
sure that "absolutely, positively" all packages that come in today will go out today.
PERFORMANCE MEASURES.
To change the way we look at our manufacturing output; we need to change the way we measure
our performance. Instead of measuring classical efficiency and utilization, maybe we should
measure customer service, schedule performance and other measures of continuous improvement.
One very successful method I see being used is to measure how well we respond to delivery of
our product to the customer's request date. One company does very well. See Figure 4. "But our
customers have unrealistic expectations", you say. Well, yes they do but that's the standard by
which we should be judged. So let's start measuring where we are and start the process of
continuous improvement.
Another company adds a nice companion measure. Remember how cycle counting looks at the
process of inventory control in order to find and fix the causes of errors? Why not use the same
concept on orders shipped late? We can look at reasons why orders are late, stratify the reasons
and fix the cause for the reasons.
Another measure I like is schedule adherence as it relates to lead time. Set a planned lead time
such as 15 days as the company did in Figure 6. The company posts the goal out on the shop floor
and gets everyone on the team to work towards continuous improvement. As you can see through
the month of September the team was able to beat the goal. Measure the lead time it takes for the
product to get through the shop; focus on it and it will improve.

CONCLUSIONS.
There is an effective compatibility between MRPII For Planning and JIT For Execution. The
common thread is to be searching for continuous improvement. As lead time shortens in our own
shop, use JIT visual techniques to flex capacity and shorten cycle time. Then we must simplify
the planning system. Partnering with our customer to remove variability from the process allows
us to use the MRPII Planning System to work with our suppliers to commit their capacity
therefore, adding dependability to our supply of raw materials.
ERP
Most purchasing and supply management professionals employ some type of automated system
or systems in their respective organizations to process purchasing-related information, such as
purchase orders, requisitions, request for quotations, and other documents. However, in many
cases, the level of information integration and exchange within your business enterprise may be
somewhat limited. The system may help you process the information more quickly, but does it
extend beyond that? More specifically, how does your inventory and requisitioning system
receive signals or input as to what to buy, how much to buy, when it is needed, and so forth? Is
there any type of information linkage between your planning and forecasting system (assuming
you have such a system) and your inventory or procurement system? Can you electronically link
between scheduled/planned work and bills of material, ultimately converting this to a system-
initiated materials requirement? Can you track total costs specific to an asset within your
organization? Can you seamlessly integrate your purchasing, receiving, accounts receivable,
accounts payable, general ledger, manpower management, equipment maintenance, and asset
management records? Can you accurately forecast impending equipment failure (predictive
maintenance) and the costs associated with owning an asset? These questions lead to the
discussion of enterprise resource planning (ERP) systems, how they affect an organization, and
how they can be successfully implemented.
The Purpose of ERP
The primary purpose behind ERP systems or applications is to create a seamless integration of
interrelated information across the business enterprise. Recent software providers‘ solutions are
broadening this theme further by adding new modules associated with workflow, supply chain
management, shop floor control, capacity planning, finance, logistics, dispatching, constraint
management, and human resources. While this may sound interesting, what does it mean to you
in your environment?
On the supply management side, ERP systems offer purchasing functions the potential to:
 Leverage organization-wide purchasing volumes
 Accurately forecast supply demands
 Automate tactical processes, such as purchase orders
 Generate reports independently to identify cost saving opportunities
 Integrate supply capacity information with customer demands

 Leverage data accumulated by other functions in the organization
Enterprise Resource Planning: In a Nutshell
Enterprise Resource Planning: This is a system of software programs that ties various business
functions together. Typically, the program consists of modules for functions such as finance,
manufacturing, purchasing, logistics, sales, and human resources. Because of the integrated
nature of these systems, the different functions can relate, analyze, and access information for a
competitive advantage.
Booming Business: According to AMR Research, a market analysis firm specializing in

enterprise applications and enabling technologies, the ERP market will reach $66.6 billion in
2003.
A Typical Scenario
Many large organizations employ different large-scale materials management systems (mainframe
hosted). Each of these systems is functional from a standpoint of producing purchasing and stores
related documents, allowing dock receivings and accounts payable matching and payment
generation. However, that is often the outer extent of the systems. In many cases, the primary
customer of the materials organization is the maintenance and operations departments. However,
there is no linkage or connectivity between the production planning and maintenance scheduling
functions and the inventory, requisitioning, stores, and purchasing functions. Essentially,
professionals produce plans and forecasts in separate systems and then manually enter the data in
the inventory/stores systems in order to generate a demand on the purchasing function. Ultimately
this results in redundant entry of data, time lags, bottlenecks, increased cycle time, increased
inventory, and significant manual coordination. Frequently, for MRO based commodities, there is
no forecasting mechanism available; you "guesstimate" what your future needs might be based on
past activities. This is similar to attempting to drive your car forward while only looking in the
rearview mirror.
This typical scenario might lead an organization to search for a better system. Perhaps a group of
materials and information technology personnel from the organization participate in a software
demonstration provided by an ERP systems supplier. The experience convinces the group that
they have been missing a significant opportunity to make a quantum step in how to manage the
business. Business systems technology has changed dramatically, but many professionals —
because they‘re content with current systems — are just not aware of the new technology that has
evolved.
How can a simple demonstration lead to successful implementation of today‘s latest technology?
Why would an organization choose this route? Instead of the above scenario, organizations are
looking for a system that would receive orders and automatically send information upstream to
production, purchasing, and suppliers. At the same time, inventory, materials, and capacity
requirements are made available so that attainable delivery dates can be set. The system
communicates to finance and receiving regarding expected invoices and materials. Internally,
purchases are fully automated throughout the organization. Throughout the entire process, data is
in real time and can be pulled, assessed, and shared with suppliers to optimize their contribution.

The Reach of ERP
The following functions can be encompassed in the enterprise resource planning system:
General ledger — integrates with purchasing, inventory, stores, asset management, payroll,
accounts payable, accounts receivable, budgeting, fixed asset management, treasury, and cost
accounting functions.
Payroll — directly integrates labor reporting features and can handle account and preparation of
checks.
Fixed assets — manages depreciation and other factors associated with buildings, property, and
equipment.
Human resources — automates personnel management processes, including personnel records,
recruitment, and business travel. This function integrates with the payroll, training, and labor
management modules. It can also manage safety management and hazmat/environmental
exposure.
Production/manufacturing — integrates with production scheduling, shop floor planning, order
entry, requisitioning, stores, purchasing, and logistics.
Maintenance — integrates with asset management; warranty tracking; preventive, predictive,
and scheduled maintenance; project management; purchasing; stores; inventory; and general
ledger.
Project management — monitors costs and work schedules on a project-by-project basis.
Customer service management — administers installation-based service agreements and checks
contracts and warranties when customers call for help.
ERP solutions are constantly evolving into larger applications as the supplier either produces
additional modules for integration or develops partnerships with third-party suppliers of value-
added functionality that can be seamlessly integrated with the base product to expand its
capability. Examples of this are:
 Warehouse management systems (WMS)
 Supply chain management (SCM)
 Computerized maintenance management systems (CMMS)
 Enterprise asset management systems (EAM)
 Electronic document management systems (EDMS)
 Forecasting algorithms
 Supplier performance evaluation
 Wireless mobile computing devices for remote access
 Bar code systems
 Graphical warehouse models
 Asset optimization modeling
 Predictive maintenance forecasting/modeling
 Capacity planning
 Transportation management
 Reporting (report writers)
 Data warehousing

Is ERP Right for Your Organization?
When considering whether or not your organization could benefit by moving from an existing
legacy system, multiple systems, or no system at all to an ERP environment, consider the
following points.
 A change to a new system might be required if your current system(s) no longer supports
your needs. For example, to obtain data on total spending for a facility, is information systems (IS)
support required? A new system would allow purchasing and supply management to generate
such reports independently.
 Current systems are inefficient if they require duplicated efforts in data entry or
information processing. For example, as purchases are made, an improved system routes data to
receiving, inventory, and finance accordingly.
 Has your organization experienced mergers and acquisitions, resulting in several
independent systems, which have difficulty communicating with each other?
 Your motivation to purchase an ERP system should be based on the desire to seamlessly
integrate the primary business systems within your organization. This means that there must be a
thorough understanding of the business functions prior to selecting and implementing a system.
There must also be a willingness to change among all functions within your organization.
 Typically, ERP systems are sold to customers based on an expected return on investment
(ROI). If this is the basis on which you are buying the system, and you suspect your executive
management will base the project‘s success measure on, ensure you have good baseline data that
can be measured against post-completion results. The average investment for a new ERP
implementation can range anywhere from $2 million to $4 million, depending on the size of the
company and the chosen supplier. You will have to determine a business plan that shows the
payback for this investment — typically within one to three years.
 Selecting and implementing a system will require a project team committed to the task. In
addition to internal resources, many organizations choose a third-party consulting firm to assist in
the implementation. Internal resources will be dedicated to this project for the duration
(potentially on a full-time basis) so organizations will have to make provisions in the individuals‘
work areas accordingly.
 Data will be a critical path. While data conversion, migration, and scrubbing will be time
consuming, applying sufficient resources prior to initiating this process to plan and strategize how
the data will be used post-implementation is essential in order for your clients to effectively use
the product once it has been implemented.

ERP IN MOTION
Here is a typical example that demonstrates how various modules of an ERP system work
together. You can see that the system employs a holistic approach to managing data that connects
logical business functions and provides needed information at the point of use without having to
integrate a variety of freestanding systems. In this example, an internal business unit (operator)
has created a work order to repair a piece of capital equipment.
Once an activity has been performed and historical data has been generated, future jobs have a
baseline against which they can be scheduled and measured on factors such as cost, expected bill
of labor, bill of equipment, or bill of materials. Of significant benefit is that these various bills
only need be created one time in the system and then associated with asset work orders when
future activities require the same. In these situations, the following can be avoided; manual
scheduling of resources, human interaction to ensure availability of materials, physical traveling
of paper for approvals and routing, and repeat trips to in-plant stores for parts that were not
anticipated. With these activities eliminated, an organization is able to reap the following benefits:
 Increased productivity for maintenance personnel
 More efficient scheduling of crews and assets

 Reduced paperwork
 Reduced overtime requirements
 Reduced inventory requirements
 Reduced stock-outs and work stoppages due to materials shortages
 Improved reporting
 Capability to better understand components of cost and failure analysis
 Improved internal customer service
 Increased availability (uptime) of assets, which may lead to improved asset utilization (or
less capital equipment needs)
Project Manager
According to the GartnerGroup, Inc., a successful project manager
 is flexible  has ERP experience

 is disciplined  has business experience
 is a quick learner  has political clout
 is a good decisionmaker  has a formal education
 is well liked
 motivates staff
RESOURCES
If you are interested in learning more about ERP applications, there are numerous sources that
can provide information that may be of value. The following are independent research
organizations that evaluate and report on software and technology.
GartnerGroup. GartnerGroup provides research, analysis, consulting, measurement, decision
evaluation, and product and supplier selection tools regarding the information technology
industry.
www.gartner.com
Aberdeen Group. Aberdeen Group provides IT consulting and market strategy advice, and
publishes research reports and papers on information technology topics.
www.aberdeen.com
AMR Research. AMR Research is an industry and market analysis firm specializing in enterprise
applications, underlying architectures, and related business and technology trends.
www.amrresearch.com

Forrester Research. Forrester is an independent research firm that analyzes the future of
technology change and its impact on businesses, consumers, and society.
www.forrester.com
Yankee Group. The Yankee Group specializes in IT research and advisory services, focusing on
the areas of strategic planning assistance, technology forecasting, and IT industry analysis.
www.amrresearch.com
The following Web sites contain helpful reference and resource information on ERP systems.
They include articles about ERP, user discussion forums, supplier evaluations and contact
information, industry news reports, and several links to additional ERP resources.
IT toolbox Portal for ERP
www.erpassist.com
ERP-People.com
www.erp-people.com
ERP Supersite
www.erpsupersite.com
The ERP Fan Club and User Forum
www.erpfans.com
ERP Hub
www.erphub.com
CRM AND SRM: KEYS TO EXCELLENCE
A ew report from Cap Gemini Ernst & Young found overall operational excellence can best be
achieved by the marriage of point solutions with strategic business objectives.
The report, Operations Excellence: The Transition from Tactical to Strategic Supply Chains,
examines how companies are achieving operational excellence in the supply chain through a
number initiatives, but central to its findings is the integration of CRM (Customer Relationship
Management) with SRM (Supplier Relationship Management) systems to increase supply chain
visibility, efficiency and overall customer satisfaction.
What the study found was when managers take into account all areas of the company the supply
chain touches and incorporate the needs of those business units into their overall SCM strategy,
they have a much greater chance to achieve operational efficiencies that not only save money but
add to top-line performance, said Tony Ross, one of the study's authors and a senior manager at
Cap Gemini.
"When you put together your supply chain IT strategy, don't just bring in the transportation guy,
and the warehouse guy, and the order management guy, but bring in the folks from CRM and
marketing and sales, the people they all touch," said Ross. "So when you put that strategy together,
you're getting the IT system you need to achieve what your internal and external customers need
and a whole lot of people just completely over look that."

Operations excellence is the goal because too much time, energy and resources are being used by
firms on point solutions, which address problems, not processes, and tend to be siloed by nature,"
said Mary Holcomb, one of the study's authors and an associate professor of logistics &
transportation in the College of Business at the University of Tennessee. "Instead, operations
excellence puts the focus on solutions that are integrated with the rest of the firm's infrastructure
(like CRM) and its supply chain partners (SRM). It is an end-to-end perspective, with tactics and
strategy aligned to accomplish the goal."

PART III GREEN LOGISTICS
Introduction: The Issue of Green Logistics

The two words that make up the title of this chapter are each charged with meaning, but
combined, they form a phrase that is particularly evocative. ‗Logistics‘ are at the heart of modern
transport systems. As has been demonstrated earlier, the term implies a degree organization and
control over freight movements that only modern technology could have brought into being. It
has become one of the most important developments in the transportation industry. ‗Greenness‘
has become a code-word for a range of environmental concerns, and is usually considered
positively. It is employed to suggest compatibility with the environment, and thus, like ‗logistics‘
is something that is beneficial. When put together the two words suggest an environmentally-
friendly and efficient transport and distribution system. The term has wide appeal, and is seen by
many as eminently desirable. However, as we explore the concept and its applications in greater
detail, a great many paradoxes and inconsistencies arise, which suggest that its application may
be more difficult than what might have been expected on first encounter.
We begin by considering how the term has been developed and applied in the transportation
industry. Although there has been much debate about green logistics over the last ten years or so,
the transportation industry has developed very narrow and specific interests. When the broader
interpretations are attempted it will be shown that there are basic inconsistencies between the
goals and objectives of ‗logistics‘ and ‗greenness‘. We conclude by exploring how these
paradoxes might be resolved.
Development and Application of Green Logistics

In common with many other areas of human endeavor, ‗greenness‘ became a catchword in the
transportation industry in the late 1980s and early 1990s. It grew out of the growing awareness of
environmental problems, and in particular with well-publicized issues such as acid rain, CFCs
and global warming. The World Commission on Environment and Development Report (1987),
with its establishment of environmental sustainability as a goal for international action, gave
green issues a significant boost in political and economic arenas. The transportation industry is a
major contributor to environmental degradation through its modes, infrastructures and traffics
(Banister and Button 1993; Whitelegg 1993).
The developing field of logistics was seen by many as an opportunity for the transportation
industry to present a more environmentally-friendly face. During the early 1990s there was an
outpouring of studies, reports and opinion pieces suggesting how the environment could be
incorporated in the logistics industry (Muller 1991; Murphy et al. 1994; Tanja 1991). It was
reported that the 1990s would be ‗the decade of the environment‘ (Kirkpatrick 1990).
As we look back on the decade we can observe that interest in the environment by the logistics
industry manifested itself most clearly in terms of exploiting new market opportunities. While
traditional logistics seeks to organize forward distribution, that is the transport, warehousing,
packaging and inventory management from the producer to the consumer, environmental
considerations opened up markets for recycling and disposal, and led to an entire new sub-sector:
reverse logistics. This reverse distribution involves the transport of waste and the movement of
used materials. While the term ‗reverse logistics‘ is widely used, other names have been applied,
such as ‗reverse distribution‘, ‗reverse-flow logistics‘, and ‗green logistics‘ (Byrne and Deeb

1993). Inserting logistics into recycling and the disposal of waste materials of all kinds, including
toxic and hazardous goods, has become a major new market. There are several variants. An
important segment is customer-driven, where domestic waste is set aside by home-dwellers for
recycling. This has achieved wide popularity in many communities, notably because the public
became involved in the process. A second type is where non-recyclable waste, including
hazardous materials, is transported for disposal to designated sites. As land fills close to urban
areas become scarce, waste has to be transported greater distances to disposal centers. A different
approach is where reverse distribution is a continuous embedded process in which the
organization (manufacturer or distributor) takes responsibility for the delivery of new products as
well as their take-back. This would mean environmental considerations through the whole life-
cycle of a product (production, distribution, consumption and disposal). For example, BMW is
designing a vehicle whose parts will be entirely recyclable (Giuntini and Andel 1995).
How the logistics industry has responded to the environmental imperatives is not unexpected,
given its commercial and economic imperatives, but by virtually overlooking significant issues,
such as pollution, congestion, resource depletion, means that the logistics industry is still not very
‗green‘. This conclusion is borne out by published surveys. Murphy et al (1994) asked members
of the Council for Logistics Management what were the most important environmental issues
relating to logistics operations. The two leading issues selected were hazardous waste disposal
and solid waste disposal. Two thirds of respondents identified these as being of ‗great‘ or
‗maximum‘ importance. The least important issues identified were congestion and land use, two
elements usually considered of central importance by environmentalists. When asked to identify
the future impact of environmental issues on logistical functions, again waste disposal and
packaging were chosen as leading factors. Customer service, inventory control, production
scheduling – logistical elements –were seen to have negligible environmental implications.
By the end of the 1990s much of the hyperbole and interest in the environment by the logistics
industry had been spent. A count of the number of articles with an environmental orientation in
three journals between 1997 and 1998 revealed that they represented an insignificant proportion
of all articles (see Table 1). Most of the articles that were identified as having an environmental
content dealt with hazardous waste transport issues.
This suggests that at the beginning of the 21st Century the logistics industry in general is still a
long way from being considered green. Reverse logistics has been its major environmental pre-
occupation. While this is an important step, recycling being one of the important elements in
sustainability, many other environmentally significant considerations remain largely unaddressed.
Are the achievements of transport logistics compatible with the environment?

The Green Paradoxes of Logistics in Transport Systems
If the basic characteristics of logistical systems are analyzed, several inconsistencies with regards
to environmental compatibility become evident. Four basic paradoxes are discussed below.
1 Costs
The purpose of logistics is to reduce costs, notably transport costs. In addition, economies of time
and improvements in service reliability, including flexibility, are further objectives. Corporations
involved in the physical distribution of freight are highly supportive of strategies that enable them
to cut transport costs in the present competitive environment. The cost-saving strategies pursued
by logistic operators are often at variance with environmental considerations, however.
Environmental costs are often externalized. This means that the benefits of logistics are realized
by the users (and eventually to the consumer if the benefits are shared along the supply chain), but
the environment assumes a wide variety of burdens and costs. Society in general, and many
individuals in particular, are becoming less willing to accept these costs, and pressure is
increasingly being put on governments and corporations to include greater environmental
considerations in their activities. Although there is a clear trend for governments, at least in their
policy guidelines, to make the users pay the full costs of using the infrastructures, logistical
activities have largely escaped these initiatives. The focus of much environmental policy is on
private cars (emission controls, gas mixtures and pricing). While there are increasingly strict
regulations being applied to air transport (noise and emissions), the degree of control over
trucking, rail and maritime modes is less. For example diesel fuel is significantly cheaper than
gasoline in many jurisdictions, despite the negative environmental implications of the diesel
engine. Yet trucks contribute on average 7 times more per vehicle-km to nitrogen oxides
emissions than cars and 17 times more for particulate matter. The trucking industry is likely to
avoid the bulk of environmental externalities it creates, notably in North America.
The external costs of transport have been the subject of extensive research. Early gross estimates
(Quinet, 1989) suggested congestion costs to account on average for 8.5% of the GDP and from
2.0 to 2.5% for safety. Recent estimates in Europe suggest that annual costs amount to a figure
between 32 and 56 billion ECU (EU 1996). Cooper et al (1998) estimate the costs in Britain at 7
billion ECU, or twice the amount collected by vehicle taxation. The hub-and-spoke structure
(Figure 1) has characterized the reorganization of transportation networks for the past 20 years,
notably for air and rail and maritime freight transportation. It has reduced costs and improved
efficiently through the consolidation of freight and passengers at hubs. Despite the cost savings in
many cases, the flows, modes and terminals that are used by pursuing logistical integration are the
least sustainable and environmentally friendly. The hub-and-spoke structure concentrates traffic
at a relatively small number of terminals. This concentration exacerbates local environmental
problems, such as noise, air pollution and traffic congestion.
In addition, the hub structures of logistical systems result in a land take that is exceptional.
Airports, seaports and rail terminals are among the largest consumers of land in urban areas. For
many airports and seaports the costs of development are so large that they require subsidies from
local, regional and national governments. The dredging of channels in ports, the provision of sites,
and operating expenses are rarely completely reflected in user costs. In the United States, for
example local dredging costs, were nominally to come out of a harbor improvement tax but this
has been ruled unconstitutional and channel maintenance remains under the authority of the US
Corps of Army Engineers. In Europe, national and regional government subsidies are used to

assist infrastructure and superstructure provision. The trend in logistics towards hub formation is
clearly not green. The actors involved in logistical operations have a strong bias to perceive green
logistics as a mean to internalize cost savings, while avoiding the issue of external costs. As
underlined earlier, a survey among the managers of logistical activities pointed out that the top
environmental priority is reducing packaging and waste (Murphy et al 1994). Managers were also
strongly against any type of governmental regulation pertaining to the environmental impacts of
logistics. These observations support the paradoxical relationship between logistics and the
environment that reducing costs does not necessarily reduce environmental impacts.
2 Time / Speed
In logistics, time is often the essence. By reducing the time of flows, the speed of the distribution
system is increased, and consequently, its efficiency. This is achieved in the main by using the
most polluting and least energy efficient transportation modes. The significant increase of air
freight and trucking is partially the result of time constraints imposed by logistical activities. The
time constraints are themselves the result of an increasing flexibility of industrial production
systems and of the retailing sector. Logistics offers door-to-door (DTD) services, mostly coupled
with just-in-time (JIT) strategies. Other modes cannot satisfy the requirements such a situation
creates as effectively. This leads to a vicious circle (Figure 2). The more physical distribution
through logistics is efficient, the less production, distribution and retailing activities are
constrained by distance. In turn, this structure involves a higher usage of logistics and more ton-
km of freight transported. There is overwhelming evidence for an increase in truck traffic and a
growth in the average length of haul (Cooper et al 1998), and although McKinnon (1998) has
suggested that JIT is not greatly increasing road freight volumes (italics added), it cannot be
considered a green solution. The more DTD and JIT strategies are applied, the further the
negative environmental consequences of the traffic it creates.
3 Reliability
At the heart of logistics is the overriding importance of service reliability. Its success is based
upon the ability to deliver freight on time with the least threat of breakage or damage. Logistics
providers often realize these objectives by utilizing the modes that are perceived as being most
reliable. The least polluting modes are generally regarded as being the least reliable in terms of
on-time delivery, lack of breakage and safety. Ships and railways have inherited a reputation for
poor customer satisfaction, and the logistics industry is built around air and truck shipments... the
two least environmentally-friendly modes.

4 Warehousing
6
Logistics is an important factor promoting globalization and international flows of commerce.
Modern logistics systems economies are based on the reduction of inventories, as the speed and
reliability of deliveries removes the need to store and stockpile. Consequently, a reduction in
warehousing demands is one of the advantages of logistics. This means however, that inventories
have been transferred to a certain degree the transport system, especially the roads. This has been
confirmed empirically. In a survey of 87 large British firms cited by McKinnon (1998), there had
been a 39 per cent reduction in the number of warehouses and one third of the firms indicated an
increased amount of truck traffic, although the increase was thought to be small in most cases.
Inventories are actually in transit, contributing still further to congestion and pollution. The
environment and society, not the logistical operators, are assuming the external costs. Not all
sectors exhibit this trend, however. In some industrial sectors, computers for example, there is a
growing trend for vertical disintegration of the manufacturing process, in which extra links are
added to the logistical chain. Intermediate plants where some assembly is undertaken have been
added between the manufacturer and consumer. While facilitating the customizing of the product
for the consumer, it adds an additional external movement of products in the production line.
5 E-commerce
The explosion of the information highway has led to new dimensions in retailing. One of the most
dynamic markets is as e-commerce. In 1998, inter-businesses transaction undertaken through e-
commerce accounted for 43 billion $US while business to consumer transactions accounted for 8
billion $US. In 1999, e-commerce boomed to reach 150 billion $US, 80% of which was between
businesses. These numbers are expected to reach 1.3 trillion and 108 billion $US respectively by
2003. In 1999, the computer manufacturer and distributor Dell sold 15 $US million worth of
computers a day strictly from orders placed on its Web Site.
This is made possible by an integrated supply chain with data interchange between suppliers,
assembly lines and freight forwarders. Even if for the online customers there is an appearance of a
movement-free transaction, the distribution online transactions create may consume more energy
than other retail activities. The distribution activities that have benefited the most from e-
commerce are parcel-shipping companies such as UPS and Federal Express that rely solely on
trucking and air transportation. Information technologies related to e-commerce applied to
logistics can obviously have positive impacts. For instance, the National Transportation Exchange
(NTE) is an example where freight distribution resources can be pooled and where users can bid
through a Web Site for using capacities that would have otherwise been empty return travel. So
once again, the situation may be seen as paradoxical.
The consequences of e-commerce on Green Logistics are little understood, but some trends can
be identified. As e-commerce becomes more accepted and used, it is changing physical
distribution systems. The standard retailing supply chain coupled with the process of economies
of scale (larger stores; shopping malls) is being challenged by a new structure. The new system
relies on large warehouses located outside metropolitan areas from where large numbers of small
parcels are shipped by vans and trucks to separate online buyers.

This disaggregates retailing distribution, and reverses the trend towards consolidation that had
characterized retailing earlier. In the traditional system, the shopper was bearing the costs of
moving the goods from the store to home, but with e-commerce this segment of the supply chain
has to be integrated in the freight distribution process. The result potentially involves more
packaging and more tons-km of freight transported, especially in urban areas.
Traditional distribution systems are thus ill fitted to answer the logistical needs of ecommerce.
How green are logistics when the consequences of its application, even if efficient and cost
effective, have led to solutions that may not be environmentally appropriate?
Discussion and Evaluation

Our overview suggests that green logistics is still a long way from being achieved. The
environment is not a major preoccupation or priority in the industry itself. The exception is where
reverse distribution has opened up new market possibilities based upon growing societal concerns
over waste disposal and recycling. Here the environmental benefits are derived rather than direct.
The transportation industry itself does not present a greener face, indeed in a literal sense reverse
logistics adds further to the traffic load. The manufacturers and domestic waste producers are the
ones achieving the environmental credit.
It is not a question of whether or not the logistics industry will have to present a greener face.
Pressures are mounting from a number of directions that are moving all actors and sectors in the
economy in the direction of increasing regard for the environment. In some sectors this is already
manifest, in others, such as the logistics industry, it is latent. The issue is when and in what form
it will be realized. Three scenarios are presented and discussed.

1. A top-down approach where ‗greenness‘ is imposed on the logistic industry by government
policies;
2. A bottom-up approach where environmental improvements are coming from the
industry itself;
3. A compromise between the government and industry, notably through certification.
While not mutually exclusive, they each present different approaches and implications.
First is that government action will force a green agenda on the industry, in a top-down approach.
Although this appeared as the least desirable outcome from the survey of logistics managers
(Murphy et al 1994), it is already evident that government intervention and legislation are
reaching ever more directly over environmental issues. In Europe there is a growing interest in
charging for external costs, as the EU moves towards a ‗fair and efficient‘ pricing policy. Cooper
et al (1998) estimate that this could bring about a rise of 20-25 per cent in transport costs. While
there is some evidence that price elasticities are low in the logistics industry, around -0.1
(Bleijenberg 1996), the extent of the impact is more likely to be determined by how quickly the
tax is applied. A sharp increase in costs could have a more serious impact than a more gradual,
phased-in tax. In North America there is a growing interest in road pricing, with the re-
appearance of tolls on new highways and bridges built by the private sector, and by congestion
pricing (Fielding), especially in metropolitan areas. As yet there have been no studies of the
effects on the logistics industry, but higher road costs are a clear outcome of policy intervention.
Pricing is only one aspect of government intervention. Legislation controlling the movement of
hazardous goods, reducing packaging waste, stipulating the recycled content of products, the
mandatory collection and recycling of products are already evident in most jurisdictions. Indeed,
it is such legislation that has given rise to the reverse logistics industry. Truck safety, driver
education, limits on driver‘s time at the wheel, are among many types of government action with
a potential to impact the logistics industry.
A difficulty with government intervention is that the outcomes are often unpredictable, and in an
industry as complex as logistics, many could be unexpected and unwanted. Environmentally-
inspired policies may impact on freight and passenger traffic differentially, just as different modes
may experience widely variable results of a common regulation. Issues concerning the greenness
of logistics extend beyond transport regulations. The sitting of terminals and warehouses are
crucial to moving the industry towards the goal of sustainability, yet these are often under the
land use and zoning control of lower levels of government whose environmental interests may be
at variance with national and international bodies.
If a top-down approach appears inevitable, in some respects at least, a bottom-up solution would
be the industry preference. Its leaders oppose leaving the future direction to be shaped by
government action. There are several ways a bottom-up approach might come about. As
demonstrated by the example of reverse logistics, these occur when the business interests of the
industry match the imperatives of the environment. One such match is the concern of the logistics
industry with empty moves. McKinnon (1998) reports that improvements in fleet management
and freight distribution in Britain between 1983 and 1993 reduced the proportion of empty moves
by 11 per cent, which, ceteris paribus cut CO2 emissions by 720,000 tons per year. With the
growing sophistication of fleet management and IT control over scheduling and routing, further
gains are achievable.

Less predictable, but with a much greater potential impact on the greenness of the industry, are
possible attitudinal changes within logistics and without. These changes are comparable of that
which has already occurred in recycling. There has emerged striking public support for domestic
recycling. Although this has been mandated to some degree in some jurisdictions, the mantra of
the three R‘s (reduce consumption, reuse, and recycle) has achieved unparalleled popularity. This
has been extended by some firms in successfully marketing their compliance and adoption of
green strategies. Firms have found that by advertising their friendliness towards the environment
and their compliance with environmental standards, they can obtain an edge in the marketplace
over their competitors.
A comparable situation has been investigated in the context of the logistics industry by Enarsson
(1998). He argues that purchasing departments become a critical point in the move towards
applying green logistics. Traditionally, price and quality characteristics formed the basis of choice,
but because environment preservation is seen as desirable in general, greenness can become a
competitive advantage. Ultimately, pressure from within the industry can lead to greater
environmental awareness and respect. Companies that stand apart will lose out because
purchasers will demand environmental compliance.
Somewhere between the bottom-up and top-down approaches are the moves being implemented
with environmental management systems. Although governments are involved in varying degrees,
a number of voluntary systems are in place, notably ISO 14000 and EMAS (Environmental
Management and Audit System). In these systems firms receive certification on the basis of
establishing an environmental quality control tailored to that firm, and the setting up of
environmental monitoring and accounting procedures. Obtaining certification is seen as evidence
of the firm‘s commitment to the environment, and is frequently used as a public relations,
marketing, and government relations advantage.
Decisions to proceed with a request for certification have to come from the highest
decisionmaking levels of corporations, and involve a top to bottom assessment of operations.
This represents a fundamental commitment of the corporation to engage in environmental
assessment and audit that represent a significant modification of traditional practices, in which
efficiency, quality and cost evaluations prevailed. So far, there has been no research into the
compliance of logistics firms with ISO 14000, although several large corporations with in-house
logistics operations such as Volvo have been studied (Enarsson 1998).
Skeptics could argue that the paradoxes discussed in this paper make it impossible for the
logistics industry to become any greener than it is today. The internal inconsistencies between the
goal of environmental sustainability and an industry that gives undue preference to road and air
transport could be seen as being irreconcilable. Yet internal and external pressures promoting a
more environmentally-friendly logistics industry appear to be inexorable. While we have
identified three possible directions by a greener logistics industry may emerge, it is probably more
realistic to consider that elements of all three will help shape the industry of the future.

Blueprint for Green Logistics
A healthy environment is critical for efficient transport and transport, through its capacity to open
markets and promote economic growth is essential for effective and lasting environmental
management. But the growing internationalization of trade has broaden the concept of logistics to
global logistics. Globalization and global logistics has in many instances harmed the environment
by encouraging governments and firms to compete on the international market by lowering
environmental standards in certain countries while maintaining higher standards in rich countries.
As a result, there has been growing support for environmental initiatives undertaken at the
international level and an increasing reliance on local communities to address environmental
problems as the underlying environmental issues differ between and within countries. Therefore,
the successful implementation of green logistics must come from the complex interplay of both
global and local environmental governance to strengthen state efforts. Indeed, the most important
policy recommendations, implementations and operationalization of green logistics that would
work occur at the local level. Obviously, international trade is not more harmful to the
environment that regional or local trade, but proper assessment of green logistics must be integral.
Most scenarios on the future of world trade and freight transport rest on multimodal infrastructure
sharing and rising energy consumption. Therefore, there is a need to promote a regional approach
to green logistics. The idea is not for smaller and more frequent shipments which would result in
more trips by smaller vehicles, but rather to reduce the number of trips. The objective is to
minimize movements through land use policies that reduces the level and geographical separation
of industrial activities. While the extent to which regions contribute to logistics is unclear, their
role is often crucial to enable decisive and effective action to protect the environment. Since the
conflict between economic significance of logistics and the impact on the environment is first and
foremost a political topic, green logistics will most effectively be implemented in settings with
strong institutional factors responsible for enforcing and monitoring environmental sustainability.
Therefore, further government intervention promoting greater environmental regulation appears
inevitable.
Conclusions
Further government intervention promoting greater environmental regulation appears inevitable.
Global, continental, national and local environmental legislation is already taking hold. For the
most part this legislation is popular, and while there is considerable industry resistance to
increased regulation, the scientific and popular evidence of environmental problems is mounting.
Concerns over congestion, land take, environmental degradation are forcing legislators to be seen
to be doing something, even if the full impacts remain unclear.
At the same time, individual logistics firms are finding a match between environmental
considerations and profitability. It is becoming acceptable within the industry to adopt green
measures. Sometimes they reduce costs, but more often than not they lead to more intangible
benefits such as image and reputation enhancement. It is here that environmental management
systems, such as ISO 14000, may offer opportunities to green the logistics industry.

PART IV PURCHASING
Accounting & Finance for Purchasing
Purpose of accounting and finance.
Financial records based on sales volume in dollars (also referred to as revenue) and expenses or
costs of doing business reflect the health and profitability of the business. Such records are
required by the taxing authorities and other outside parties as well as managers within the
company. Financial reports prepared for outside parties are considered part of Financial
Accounting. Financial reports prepared for managers within the company are considered part of
Cost or Managerial Accounting.
Why purchasers should know something about accounting and finance.
It is important for purchasers to know if suppliers are financially sound. This is called financial
responsibility. Otherwise the supplier may not be able to complete a contract or deliver on time or
produce the goods and services to meet specifications. The supplier may be needed in order to
obtain information, obtain consumable items or repair components long after goods have been
delivered. Knowledge of financial statements helps the buyer predict the staying power of a
supplier. Knowledge of the supplier's organizational structure tells the buyer who will be
responsible if problems develop.
It is also important for purchasers to work with other company managers in developing,
reviewing, and analyzing financial information needed within the company to make management
decisions. In this role, the purchaser is often a member of a management team, often headed up
by the Financial Manager, the Operations Manager, or the Project Manager.
How business transactions are recorded by accounting.
Transactions are recorded in a journal. Businesses use a double entry system that requires a debit
entry and a credit entry for each transaction. Debits are a positive or improvement in assets.
Assets are what a company owns. Credits may be thought of as an increase in either liabilities or
stockholder‘s equity. In accounting terms, ―debit‖ means an entry on the left hand side of the
account, while ―credit‖ means an entry on the right hand side of the account. Each journal entry
for a debit must have a credit entry made for another account at the same time. For example, if a
company receives $20 in cash, the cash account is debited to show cash has been increased by
$20. If this item was carried in ―accounts receivable‖ (credit sale), the debit will be offset by
charging $20 to accounts receivable, thereby reducing the amount owed to the company. The
journal gives a chronological record of all transactions and provides some detail explaining the
transaction. Each journal entry is posted to individual ledger accounts. Debits are posted on the
left side of the account and credits are posted to the right side of the account. There are separate
accounts for cash, accounts receivable, inventory, accounts payable, and everything else showing
up on the Balance Sheet.

How accounting reports business activity.
Accounting departments prepare various reports so management can deter-mine how the business
is doing and to take corrective action if necessary. Some reports are prepared on a regular basis;
such as monthly, quarterly, and annually. Information in these reports is helpful and sometimes
required for credit rating services; such as Dun and Bradstreet. They also may be required for
stockholders, banks, and other lending institutions.
Types of accounting reports.
Balance Sheet
The Balance Sheet reflects the condition of the business at a particular point in time or rather on a
particular date. The report lists the assets (A), the liabilities (L), and the stockholder‘s equity (E),
all in dollars. The total amount of the assets must equal the combined total of the liabilities and
the stockholder‘s equity. In other words they must balance. (A = L + SE)
Assets are subdivided into Current Assets and Fixed (Long Term) Assets. Current Assets are
those such as cash or that can be converted into cash quickly (normally within the current
accounting period or one year). Fixed Assets are Capital items (like Property, Plant, and
Equipment) or those that may take longer than one year to dispose of or turn into cash. Each asset
and each liability shown on the balance sheet has a corresponding ledger account for the category.
Typical and usual current asset accounts shown on the balance sheet are Cash, Accounts
Receivable, and Inventory. Typical Fixed Assets are Land, Buildings, and Equipment. Most Fixed
Assets (other than Land) are depreciated, meaning their value is reduced in the Balance Sheet to
reflect the use, over time, of those assets.
Liabilities are subdivided into Current Liabilities and Long-Term Liabilities. Current Liabilities
are those that need to be paid within a short period of time (usually one year). Long-Term
Liabilities include Long Term Loans from the Bank or Long-Term Bonds issued by the company
in order to raise capital.
Profit and Loss Statement (Also called Earnings Statement and Income Statement)
The profit and loss statement shows the revenues (sales) and expenses of the business for a
certain period such as a month, or a quarter, or a year. The difference between the revenue (sales)
and the expenses indicates the amount of profit or loss for that period.
Cash Flow Statement
A separate report is prepared to show the inflows and outflows of cash during the accounting
period. This report normally shows the source of the inflow and the beneficiary of the outflow.

Budgets
A budget is a ―monetized plan‖ showing forecasted or ―pro-forma‖ financial statements reflecting

how the company expects to operate during a period of time. All efficient businesses prepare
and use budgets. Just like the business plans that they support, budgets are short term (less than
12 months), intermediate term (1 to 5 years) or long term (beyond 5 years).
The budgets may be made for the entire organization or by each department.
Capital Items and Fixed Budgets
Capital budgets show the amounts to be spent for capital items. Capital items are tangible durable
products such as furniture, major tooling, and equipment. Budgets for capital items are normally
fixed with a specific amount for each item or group of items because the amount to be spent can
be closely estimated. The cost of capital items is depreciated or spread over the expected life of
the product. For example, if the piece of equipment cost $100,000 and is expected to last ten
years, then the product is depreciated by $10,000 per year. In other words, the value on the books
is reduced by $10,000 per year by charging the $10,000 to depreciation expense.
Expense Items and Variable Budgets
It is preferable to use variable budgets for consumable items needed to run the business and for
products intended for resale. This is because the amount to be spent depends on the sales volume
and more must be spent on these types of items as sales go up and less should be spent if sales go
down.
Financial Planning Budgets
The controller or chief financial officer probably makes a budget that reflects anticipated income
and expenses. This major plan is used by management to approve or disallow items on the other
types of budgets. It is used to determine the need for borrowing or raising additional capital.
Manpower or Headcount Budgets
These are often made for the number of people required to operate the business. Each department
may estimate how many people are needed for the entire year or for each month of the year. Often
salaries and pay increases by job or by individual are also budgeted.
What budgets are used in purchasing
Capital budgets are established by other departments, but purchasing may need to develop
information for use both those other departments and also establish and obtain approval for a
capital budget for items needed within the purchasing department. Such items may include new
furniture, personal computers, or a copy machine for use within the purchasing operation. An
expense budget may be needed for travel to suppliers or to a seminar. A headcount budget may be
needed to maintain the same number of buyers or hire more help. On the other hand, purchasing
usually has no control over items needed for manufacturing or for inventory for resale. Those
items are usually budgeted by other departments or determined by sales volume.

Financial Analysis
It is important to evaluate the financial strength of a supplier before giving a major order to that
supplier. A strong financial position indicates that the supplier will be able to fulfill the order. It
means the supplier will have the funds or be able to obtain the funds necessary to buy any
material required. A strong financial position means the supplier will likely remain in business to
make good on any warranty and provide any needed repair parts or service for the purchased item.
Here are some of the ways financial condition may be checked.
Obtain Bank References
Contact the bank to verify the supplier has an account and how long it has been established. Ask
how much the average balance is. Ask if the supplier has a line of credit with the bank. Compare
the average balance to the accounts payable amount to determine if the supplier has sufficient
funds to cover current bills.
Contact a Credit Reporting Service
Ask Dun & Bradstreet or another credit reporting service for a credit report. Although there are
fees for these reports, it is a small price to pay for some assurance that the supplier is capable.
Often the buyer's accounting department already has paid an annual fee for a volume of such
reports and they may get the report for purchasing. The buyer must not accept all information in
the reports without question as the credit service often simply obtains the information directly
from someone at the supplier who may or may not be totally truthful.
Obtain the Supplier's Financial Statements
The buyer may obtain financial statements for analysis directly from the supplier or through the
―Edgar Website‖ maintained by the Securities and Exchange Commission or sometimes even
through a stock broker. The information is available to the public for public (Stock Exchange)
listed companies. Although private suppliers may not want to cooperate because they feel the
information is confidential, it can be pointed out that the information will not be disclosed
elsewhere and it will be used strictly to evaluate the ability of the supplier to fulfill the
requirements of the order and the ability to become a continuing source of supply. The buyer
should request the current annual statements plus annual statements for two previous years.
Observe if revenue and profit are going steadily up, down, or fluctuating. Increasing or steady
amounts are favorable, decreasing amounts unfavorable. Fluctuating revenue is cause for caution
and further analysis.

Calculate liquidity ratios.
The Current Ratio should be computed. The Current Ratio is current assets divided by current
liabilities and indicates how prepared a company is to pay its current debt. A rule of thumb is that
a Current Ratio of 2 or higher is satisfactory although the average for healthy or not so healthy
organizations may differ by business type. The Quick Ratio should also be computed. The
Quick Ratio is also referred to as the Acid Test Ratio, and is a good indicator of business strength.
The Quick Ratio is calculated by dividing Cash, Marketable Securities, and Receivables (or all
Current Assets except for Inventory) by Current Liabilities. This is a somewhat better indicator
than the Current Ratio because it eliminates the Inventory amount from the calculation since
inventory may not be as easily converted into cash when needed.
The Debt to Equity Ratio should also be computed.
This is determined by taking total liabilities (debt) and dividing by total stockholder‘s equity.
This ratio provides a quick look at how the supplier is financing his operation using debt and
equity and helps financial institutions like banks determine whether or not the supplier is ―loan
worthy‖. Too much debt compared to equity is not looked on with favor by financial
institutions.
Checking Invoices for Accuracy
Invoices should agree with purchase orders and the quantities and specifications of the goods
received should match both the purchase order and the invoice. This checking operation is not
considered a responsibility of purchasing operations and good accounting practice usually frowns
on assigning this function to buyers or other purchasing personnel. It is considered poor
accounting control. Of course, it may be necessary in a very small company that has very few
employees. Otherwise the comparisons are usually made by accounts payable personnel. Many
organizations now use the computer to make the comparisons. When discrepancies are found, the
invoices may be returned to the seller for correction or the goods may be returned to the seller.
Buyers often must resolve disputes through negotiation with the supplier when the responsibility
for errors is not clearly established.
Administration of Purchasing
How work can be divided in a multi-buyer environment.
Work volume in purchasing may be delegated to buyers by product category, part number, or by
supplier name. It is considered best to have a single buyer responsible for the same item and the
same category of items and is best to also have a single buyer or purchasing manager responsible
for the selection and evaluation of a supplier's performance.

The types of organizational structure for purchasing and the advantages and disadvantages of
each.
The organization of purchasing is often a function of the company's organizational structure.
Decentralized
A highly decentralized purchasing organization in one where every employee buys whatever he or
she needs to accomplish his or her business duties. Some new businesses or small organizations
use this method until the excessive cost of this method is discovered. Other organizations have
one purchasing agent or even an entire purchasing department at every branch or plant location.
The argument for this structure is that communications between the user and the buyer are better
and the use of local suppliers promotes good will in the community. This seems less true today
with the availability of FAX machines, e-mail, and modern transportation.
Modified
A modified system is where certain items or categories of items are purchased at a central
location such as the home office and other items are purchased locally. This is a compromise and
is well suited to situations where a local operation may be purchasing goods that are not
purchased elsewhere.
Centralized
A highly centralized purchasing operation is one where all purchases are made from one location.
Centralized purchasing provides the following advantages.
1. Buyer Specialization
Fewer buyers can be used and each buyer can spend more time learning the intricacies of the
products under his responsibility unlike the decentralized system where a purchasing agent must
know about every product that might be purchased.
2. Economies of Scale
A buyer buying for many locations has larger volumes that normally reduce the cost. Negotiations
and documentation are done once during a given period instead of many times. Duplication of
effort is avoided.
3. Supervision is Easier
A highly qualified purchasing manager can be hired to supervise buyers whereas it is unlikely that
a local branch can afford to hire expensive purchasing talent or is unlikely to have experienced
purchasing professionals available.
4. Product Standardization Reduces Costs
Product Standardization generally means that all employees and departments use the same brand,
make and model of any particular product. This can reduce costs in a few ways. Since volumes
are higher, economies of scale (as stated above) becomes a factor. Also, since parts for products
are standardized, volume discounts can be obtained. Cost of servicing products can also be
reduced because fewer service providers are required.

Staff (Specialized) Purchasers
A purchasing staff is often used by larger organizations. Staff positions usually have little direct
authority. Those in staff positions act as consultants or perform duties other than those that carry
out the everyday function of the business. Staff purchasing people write policies and procedures,
conduct audits of purchasing operations, plan and recommend actions, gather statistics, conduct
price and cost analysis, and report activities. Sometimes these staffs will conduct outsourcing
and/or offshoring from non-domestic sources. In larger organizations, staff purchasing people
award and administer ―corporate blanket order contracts‖ that are used everywhere within the
organization. Some organizations also have negotiators on their staff, particularly for larger,
more complex contracts. Purchasing staffs often report to the highest level within the
organization. They may report to a Vice President of Purchasing or the President of the company.
Those with the title of V.P. of Purchasing or Director of Purchasing may hold staff positions.
Line
Those in line positions carry out the everyday needs of the organization. Their responsibilities
relate to the core operation of the organization. In manufacturing companies, purchasing will
usually report to the Manufacturing or Operations Manager. Manufacturing/operations is most
definitely a line function. In non-manufacturing organizations, purchasing will often report to
the Chief Financial Officer, who heads the accounting and finance functions. These are most
definitely staff functions. Purchasing Managers usually perform a Staff Role for their
Manufacturing or CFO supervisors and a Line Role with respect to the buyers reporting to them.
Forms
The essential forms used in purchasing and how they are used. Numerous types of forms are used
in business and what is used varies by industry and individual company; however, the following
forms are used throughout the business world and are considered essential for good purchasing
practices.
Requisitions
Forms used by the person or department needing material or services to notify purchasing what to
buy. Normally the form is a hard copy, but some companies are now notifying purchasing through
computer screens.
Bills of Material
These are used primarily by manufacturing companies. The items listed on a bill of material are
the components used in the manufacturing process to make a finished product. However, bills of
material are sometimes also used for a long list of finished goods needed for inventory.

Request for Quotation
This form is a ―solicitation‖ and is often referred to as an RFQ. It is used to ask suppliers to
submit information about products for sale. The information may be about specifications or about
prices and terms of sale only. The latter is particularly true when the request is for an item made
to the buyer's specifications. The form usually has spaces for the names and addresses of more
than one supplier, although the copies sent to suppliers only show the name of the supplier that it
was sent to. The other names and addresses are blanked out. A space is provided for the buyer to
indicate the deadline when the form should be returned. The form is often used as an offer to buy
as well as to simply obtain information. Bids may be accepted as final offers to sell or as subject
to negotiation. For larger purchases, the ―solicitation‖ may take the form of an ―Invitation for
Bid‖, ―Invitation to Bid‖, ―Request for Bids‖, ―Request for Proposals‖, or ―Request to Negotiate‖.
Bid Analysis
A spread sheet form used by buyers to enter all the data received from each supplier so the offers
can be compared for delivered cost. The form often contains spaces to be filled in for F.O.B.
point, payment terms, price, and other information. The columnar design is ideally suited for
computer spread sheet programs such as Lotus and Excel.
Purchase Orders
This is the most important form used in purchasing for business. The form is used to notify the
selected supplier of an offer to buy a product or service or to confirm a contract already made.
The form contains spaces for the most frequently used terms and conditions. They include the
date of the order, the date delivery is required, the F.O.B. point, the method of transportation
requested, the payment terms, the quantity ordered, a description of the product, the piece price,
the extended price for the quantity ordered, and the total price of the order. It is usually a
multipart form.
In legal terms, the purchase order is considered an offer by the buying organization to buy the
goods or services identified therein. The supplier accepts the purchase order by either signing
the document (a bilateral contract) or by performing (a unilateral contract).
The original and possibly a copy are sent to the supplier. The copy is called an acknowledgment
and is to be signed and returned to the buyer. Another copy is usually sent to accounts payable
notifying accounting that it is an authorized purchase for the terms and conditions shown on the
filled in form. A copy with supporting documents is kept on file in purchasing. Standard terms
and conditions are pre-printed on the front and on the back of the form. The terms and conditions
are sometimes referred to as "boilerplate." Purchase Orders or "PO's" are prenumbered for control
purposes. No one other than an authorized buyer should give a purchase order or a purchase order
number to a supplier.
Purchase Order Revisions

This form is used to make revisions to the purchase order without the necessity of rewriting all
terms and conditions of the original. The form usually indicates that all other terms and
conditions remain the same except for the changes specified.

Purchase History
A purchase history showing prices paid, the date of purchase, the quantity purchased, and the
name of the supplier is essential to deter-mine the amount purchased with a supplier and to
evaluate prices from new suppliers or negotiate with existing suppliers. In the past all such
information was recorded on hand written records. Today, most companies obtain this
information from data stored in the computer.
Inspection Reports
Inspection report forms are not normally designed or initiated by purchasing but are important for
purchasing operations. Usually a quality control or quality assurance function issues inspection
reports. They are essential for rejected material received from outside suppliers that does not meet
specifications. The reason for the rejection must be clearly stated and sufficient information must
be included so the buyer can make a claim or negotiate a settlement with the responsible supplier.
Receiving Reports
Receiving report forms are issued by the receiving function. The form shows when the material
was received, the name of the supplier, the items and quantities that were received and any
damage or discrepancies in the shipment. The name of the carrier should also be given.
How to find sources of supply.
Supplier names, addresses, and telephone numbers along with other information about suppliers
can be obtained from various directories. A buyer can learn about new suppliers by attending
trade shows, reading trade magazines, and questioning salespeople from other suppliers. Names
of companies in foreign countries can usually be obtained from the Consul located at the foreign
embassy's office in Washington, D.C., New York, and sometimes other major cities in the U.S.
The Internet can be used to access information about products and companies. Commonly used
hard copies of directories include the following.
Yellow Pages
The Yellow Pages of telephone books are an excellent choice for quick information. They are free
for your own location. They may be ordered for other major cities at a small cost. The weakness
is that no individual names are given and product descriptions are often insufficient. There is little
or no information about a company's capabilities.
Thomas Register
This is the most common and perhaps most widely used directory for industrial buyers. It can be
purchased, or much of the information can be obtained from its Web site. Very little financial
information is included and no individual contact names are provided.

Special Product Directories
Nearly every industry has its own directory that can either be obtained from a trade magazine or
from an industry association. Most include little or no financial information and no individual
contact names.
Standard & Poor's Register of Corporation, Directors, and Executives
A valuable book that can be rented for $510 a year or checked at nearly every business library.
Not much product information, but names of officers and titles are given. Annual sales volume is
included as well as the date the business was started.
Internet
The Internet has now become a popular source to find suppliers. Search engines make locating
companies with needed products easy. Suppliers and customers can find each other no matter
what the physical distance in a short amount of time. The Internet can save a buyer much time;
however, negotiating a better price may not be as easy.
How computerization makes purchasing easier. Computers have replaced many of the tedious
manual operations that made purchasing one of the most difficult functions to administer.
Enormous amounts of typing, filing, and paper distribution were necessary and still are in
companies that have not taken advantage of the power of the computer. Not only has purchasing
reduced the labor required to process transactions, it has provided a vast amount of information
quickly and economically to help buyers negotiate better purchases.
Here are some of the ways the computer is now being used in purchasing.
Requisitioning
With a LAN (Local Area Network) individuals or departments can send their requests for
material via e-mail or by using forms contained in a purchasing program. The user types the
requirements and they appear on the buyer's monitor or may be printed out in the purchasing
office. Requirements entered in this fashion are recorded for reference later if needed.
Purchase Order Generation
Buyers enter all necessary information to generate Purchase Orders that are delivered via the
Internet or are printed out and mailed in the customary method. Some systems include a variety of
standard terms and conditions that are stored in the computer and can be selected by the buyer to
suit the transaction. P.O.'s generated this way eliminate the need to type similar information for a
particular supplier every time that supplier receives an order. Default addresses, payment terms,
and F.O.B. points are automatically inserted unless revised by the buyer. Errors are minimized
because they can be corrected on screen before the orders are printed or sent.

Purchase History
Traditionally records of purchasing activity are kept on cards that show the name of the supplier,
the quantity ordered, the date of the order, a description of the item ordered, and the purchase
order date. Some also record the date the shipment was received along with any discrepancies or
quality problems. This information is valuable to check previous prices paid. It helps determine
how much business was given to each supplier and how the suppliers performed over time.
However, it is difficult to accumulate totals for all the various items purchased from each supplier
and how much was spent with each supplier. The computer keeps most all of the required
information automatically or it can be obtained easily from the database obtained from computer
stored purchase order records.
Purchase Reports
Perhaps the most valuable benefit derived from computerization of purchasing records is the
information obtained from various reports. A listing of all suppliers and how much was spent
with each helps the buyer concentrate cost reduction efforts on those with the largest volume of
business. A listing of how much was spent on each item and on categories of items offers a
similar benefit. A listing of the number of items processed, the number of orders issued, and the
amount spent by each buyer helps in evaluating workload and in planning the staffing level.
Sourcing As stated in the preceding section many buyers now source using the Internet. This is a
timesaving tool and can be very helpful; however, remember that many times prices are fixed
when using this method.
Methods of Procurement
Procurement methods are those procedures by which the purchasing organization translates
requirements into contracts. Procurement methods establish the methods of both offer
evaluation and supplier selection. The method of procurement and the type of contract are
arguably the two most important decisions made during the advance purchasing planning process.
Low Dollar Value Procurement Methods
Most organizations employ a combination of the following procurement methods for low dollar
value purchases from commercial sources:
(1) Oral (Telephone) Ordering
(2) Blanket Purchase Agreement
(3) Written Purchase Order
(4) Imprest (Petty Cash) Fund
(5) Credit Cards

(6) Other methods, including electronic ordering, use of consignments, and purchase order drafts
Simplified, Small, or Informal Purchases
In most public sector purchasing organizations these are called "Simplified, Small, or Informal
Purchase Procedures". Generally, these procedures should not be used for the following:
(1) Purchases of other products or services in which there are complex questions to be considered
or specific contract provisions to be included (inspection and testing, insurance, patents, price
adjustments, and so forth). This is generally true in the Federal Government part of the public
sector of purchases in excess of $100,000.
(2) Purchases of research and development, complex studies and services, or other requirements
which demand judgmental technical evaluation or involved negotiations, and where award cannot
be made confidently on the basis of low price. In such purchases, formal methods should be used.
(3) Requirements for Consultant Services. Extreme caution should be used in acquiring these
services by use of small purchase methods because of the possibility of entering into improper
personal service contracts. Internal guidance on purchasing expert and consultant services
should be reviewed prior to each purchase.
If the needed goods or services cannot be provided by an established source and the expected cost
is more than the low dollar value threshold, the requisition and all supporting information should
be reviewed for completeness and forwarded to the purchasing professional with the appropriate
authority for handling the purchase. Purchasing professionals with relatively low levels of
purchasing authority can play a valuable role in the initiation of these larger dollar volume
purchases by assisting technical personnel in preparing requisitions and related supporting
material.
Oral Ordering
A good business practice which reduces the paperwork associated with small purchases is to
permit the oral placement of orders, primarily for supplies, by purchasing professionals. This
method reduces paperwork by permitting less formal documentation of the Order, as well as
encouraging faster delivery by the supplier. It is useful in situations where other simplified
methods, such as calls against blanket purchase agreements are not practical. The oral ordering
method should be considered for use when all of the following conditions can be met:
(1) The item description is simple and can easily be communicated verbally with a minimum
change of misunderstanding. Oral ordering is generally applicable to the purchase of standard
items and is not intended for special orders or nonstandard designs;
(2) The purchase does not exceed the low dollar value threshold (or the purchasing professional's
delegated procurement authority, if less);
(3) Effective competition can be obtained for purchases over a certain dollar amount, and
quotations are obtained and documented.

(4) A written or electronic PR exists;
(5) The supplier does not require a written order in advance of shipment or performance.
Conditions Inappropriate for Oral Ordering
Oral ordering should generally not be used if detailed specifications or elaborate terms and
conditions are required. If the supplier selected for award will accept an oral order, the
purchasing professional should give the supplier the oral purchase order number and the date of
order; (the oral order number is assigned in the same manner as for a written order. The supplier
should be told to include the oral order number and date on the invoice. However, if the
transaction will be covered under a blanket purchase agreement, a call or release number will be
needed in lieu of a purchase order number. If the transaction will be paid for by use of the
imprest fund, no order number is needed, but the supplier must be notified that payment will be
made in cash); the item description, unit, quantity, and price; the required delivery date and
location; quoted terms and conditions (e.g., discount, if any); method of shipment, when
applicable; F.O.B. point; method of payment (C.O.D., imprest fund, written invoice, etc.); and the
address to which the invoice will be submitted after the delivery is made, if applicable.
Documentation of Oral Orders
The oral order must be documented promptly after it is placed, normally within two (2) days.
Documentation may be accomplished by using a purchase order, a blanket purchase agreement
call, or if payment will be made by imprest fund. If all items on a requisition cannot be obtained
from one supplier, or if price or other considerations necessitate purchase from more than one
supplier, each order placed must be documented separately.
When a supplier accepts an oral order, but requires a written confirmation, the oral order may be
placed and followed promptly by a confirming written purchase order which obligates the funds
and documents the item description, the price, and the terms. A confirming written order is
normally used when the supplier requires a written purchase order document, and the need is so
urgent that the order must be entered immediately and work started before a written order can
reach the supplier and/or when the purchase is of such a nature that costs cannot be accurately
determined at the outset, and it is customary in the trade to charge for an estimate. For example,
some equipment repairs involving disassembly and inspection to determine the repairs needed
meet this qualification. In such cases, the purchasing professional should provide oral
authorization for the disassembly and inspection, and then issue a confirming purchase order for
this work plus the repair work, based on the estimate furnished by the supplier. If the cost
cannot be determined exactly but can be reasonably estimated, the purchasing professional should
issue a written purchase order in advance, showing an estimated amount, instead of sending a
confirming order later.
Written Purchase Orders
The most frequently used method for effecting small dollar value purchases is issuance of a
written purchase order. When sent to a supplier, this document acts as the purchasing

professional's offer to buy at the prices and under the terms and conditions stated. When
received and accepted by the supplier, the purchase order becomes an agreement having the same
force and effect as a formal contract. In addition, there are other, more simplified methods
which may be used instead of a written purchase order, under specified conditions, to expedite
processing and reduce the administrative burden.
Definition
A purchase order is a transaction requesting the delivery of supplies or equipment or the

performance of services. It is normally a written document, signed by a purchasing professional
and addressed to a supplier, however, it may be oral. It contains all of the terms and conditions
that will govern the delivery or performance, but it does not obligate the supplier to perform.
Unilateral Orders
When sent to a supplier without requesting the supplier to sign and return a copy, the Order is a
unilateral (one party) document. It is the purchasing professional's offer to contract, i.e., to buy
at the prices and under the terms and conditions stated. Issuing the purchase order by itself
gives no assurance that the supplier will render the requested delivery or performance, nor does it
obligate the supplier to perform.
Only when the supplier accepts the purchase order by performance does the unilateral order
become a formal contract. Contract formation by supplier performance is the normal purchase
order method. Using this method, the supplier accepts simply by proceeding to furnish the
supplies or services ordered or by proceeding to carry out the order to the point where substantial
performance has occurred. In this way, the supplier indicates consent to the purchase order's
terms and conditions.
Bilateral Orders
A bilateral (two party) purchase order becomes a formal contract when both parties have signed
the document. Using this method, the purchasing professional sends the purchase order to the
supplier requesting that the supplier sign and return a copy of the purchase order or provide any
other form of written notification indicating receipt and acceptance.
Written Purchase Order Advantages
Although the administrative cost involved with using a written purchase order is greater than for
other simplified transactions, the document affords many advantages. It can be used when
detailed specifications are involved, when a large number of line items are being purchased, and
when the dollar amount exceeds the limit for use of the imprest fund or a blanket purchase
agreement. The purchase order document contains terms and conditions necessary to specify the
rights and obligations of the parties. These may be either printed on the back of the form or
attached to it. They may be supplemented by other terms and conditions needed for a specific
transaction. Delivery orders are also documented on the same form.
Use as Delivery Orders and Receiving Documents

Purchase order forms are also used as delivery orders for purchase under indefinite delivery
contracts or Cooperative, Corporate, or Lead Division contracts. Preparation of such forms as
delivery orders is essentially the same as for preparation of a purchase order.
Most purchase orders forms are multipurpose forms which can be used not only to order materials,
but may also to receive them. The front of many purchase order forms is a format for insertion
of the particulars of the purchase, as well as a receiving report format.
A continuation sheet, provides additional space for continuing the item descriptions placed on the
purchase order form, or for continuing information in any other block when the purchase order
form does not provide enough room (for example, multiple addresses and delivery dates,
additional terms or conditions, etc.).
Written Acceptance
For some purchases, it is desirable to know immediately whether the supplier has accepted the
purchase order. In those situations, a notice indicating the requirement for an imprest fund
acceptance notice should be included in the written purchase order.
Written acceptance is often desirable when the time of delivery or performance is critical; when
the purchasing professional has experienced problems with the supplier in the past; when the
contract is for services; when the contract requires performance over an extended period of time;
when the item needed is complex (not off-the-shelf); when the purchase is of a relatively high
dollar value; or when the presence of special terms and conditions make the contract
administration more complex.
Once signed and returned by the supplier, the Purchase Order becomes a binding bilateral
contract.
Purchase Terms and Conditions
The terms and conditions are normally stated on the purchase order document. Suppliers should
be notified that the purchasing professional's terms and conditions shall govern. Nevertheless, a
supplier may acknowledge a purchase order with a standard acknowledgement form that contains
other terms and conditions, such as "prices subject to change prior to delivery" or "prepayment
required." Such an acknowledgement is a counteroffer, and the purchasing professional must
deal with it promptly. The order may be cancelled outright, or the purchasing professional may
return the counteroffer as unacceptable and attempt to negotiate acceptance of the purchasing
professional's terms. If the terms of the counteroffer are acceptable, and do not conflict with the
standard terms and conditions, they may be accepted. If there is any question as to the
acceptance of the supplier's terms and conditions, contact the Procurement Manager for advice.
If prompt action is not taken, the purchasing professional may be held to have accepted the
supplier's terms.
Unpriced Orders

The use of unpriced orders is discouraged because it is not a good business practice. There are
times, however, when it is not possible to establish a firm fixed price for supplies or services until
the work is performed. In this case, the purchasing professional may use unit prices with
ceilings or a ceiling for the total order.
Purchase Order Distribution
Purchasing professionals should distribute copies of the purchase order from at the time of
preparation, following procedures used by their respective activities.
Distribution must be limited to the minimum necessary for essential administration and
transmission of contractual information. Distribution should not be delayed until the goods are
received. The normal distribution is:
Original- Supplier
1 copy -Accounts Payable
1 copy - Warehouse Receiving (Supplies)
1 copy - Purchasing professional's PO File
1 copy - Requisitioner
Blanket Purchase Agreements
Establishing a blanket purchase agreement or blanket order with a supplier is the equivalent of
opening a charge account. It is not a contract, but rather an agreement which is convenient for
both the purchasing professional and the supplier. The agreement permits specifically named
individuals who are not purchasing professionals to place over-the-counter request instead of by
written purchase order. The purchasing professional designates such individuals, and may
revoke such designation as needed. The purchasing professional is responsible for ensuring that
designated individuals understand the operation of the agreement, and their responsibilities and
limitations when placing calls. The blanket purchase agreement utilizes consolidated invoicing
(usually monthly) for all purchases made during the previous billing period. Persons not
specifically named on blanket purchase agreements may not place calls against the blanket
agreement, even though they are delegated purchasing authority as a warranted purchasing
professional. (Of course, the purchasing professional who established the blanket may
obviously place orders, modify and terminate the blanket.) Thus, establishment of a blanket
purchase agreement with a supplier from whom frequent, repetitive purchases are made can
significantly reduce paperwork and administrative cost per order.
No Obligation to Place Orders
Under a blanket purchase agreement the purchasing professional is not obligated to place any
orders, and the supplier is not obligated to accept any orders. In other words, a blanket purchase
agreement is not enforceable against either party. An enforceable contract does not come into
being until a call against the blanket purchase agreement is given by the purchasing professional
and accepted by the supplier. In this regard, a blanket purchase agreement can be contrasted
with a definite delivery type of contract that would be created in a janitorial services situation.

Conditions Appropriate for Use
Blanket purchase agreements are useful and authorized when a variety of items in a broad class of
goods, such as hardware, is purchased from local suppliers, but the exact items, quantities, and
delivery requirements are not known in advance and may vary considerably from order to order;
when there is a need to obtain commercial sources of supply for an organization that does not
have or otherwise need authority to purchase; and when the writing of numerous purchase orders
and the processing of many invoices can be avoided.

Multiple Agreements Recommended
It is preferable to have blanket purchase agreements established with several suppliers for the
same classes of items or services. Orders can then be placed conveniently with the firm that
offers the best value, price and other factors considered, for a particular purchase, and therefore
provide for competition.
Purchasing professionals should review their past order files for recurring requirements for
related items, the files should be reviewed to see if certain suppliers tend to receive many orders.
If so, the purchasing professional should investigate the possibility of establishing a blanket
purchase agreement. As a rule of thumb, unless an average of four calls per month over a 6
month period are placed against a Blanket agreement, another procurement method may be more
economical.
Appropriate for Repetitive Ordering
The potential savings to be gained through the establishment of a blanket purchase agreement are
directly related to the number of repetitive purchases made. Occasional needs of small dollar
amounts are more appropriately handled by another purchase method, such as oral orders or
written purchase orders. Also, when the specifics of a recurring requirement are known, another
type of purchase order may afford a more appropriate vehicle.
Imprest (Petty Cash) Fund
An imprest or petty cash fund is a cash fund charged against the purchasing organization's
account and advanced by the Finance/Accounting Department to a properly authorized cashier.
Imprest funds cashiers are designated by the Finance/Accounting Officer upon the
recommendation of a higher level manager. The fund is used to make immediate cash payment
of relatively small amounts for authorized purchase of supplies and nonpersonal services. It
generally is of a revolving type, replenished to a fixed amount as the cash is spent or used.
Although the imprest fund is more properly a disbursing device than a procurement method, it is
included in this discussion of procurement methods because funds in an imprest fund can be used
to pay for purchases which are made through the oral ordering method discussed earlier. The
imprest fund should be used when such use will eliminate costly, time-consuming paperwork and
when making direct cash payment wills be advantageous to the purchasing organization.
Credit Cards
Although different organizations have different policies and procedures, the following policies
and procedures from one specific organization using a corporate type credit card were found to
provide an adequate degree of controls and safeguards. These policies and procedures could of
course be modified to meet specific organizational objectives.

Functional Responsibilities
The cardholder is the individual to whom a card is issued. The card bears this cardholder's name
and may only be used by this individual to pay for authorized purchases. All purchases that will
be paid for using the card must comply with the purchasing organization's existing policies and
procedures. Each cardholder is to reconcile his/her monthly statement and forward the
reconciled statement to his/her approving official.
An approving official will review the cardholder's monthly statement and serve as liaison with the
contacts identified in paragraphs below. The approving official will certify the cardholder's
monthly statements and ensure that payments are for purchases which are authorized and made in
accordance with existing policies and procedures. The approving official will also assist the
cardholder in resolving disputed payments. The approving official has authority to direct the
purchasing professional to instruct the bank issuer of the credit card to cancel a card at any time.
The approving official should be a high level official within the purchasing organization. A
cardholder cannot be his/her own approving official. A cardholder should not be an approving
official for his/her own supervisor.
The Purchasing Manager issues a delegation of authority to cardholders and approving officials.
The delegations normally specify the authority being delegated and any limitations on the
authority.
The bank issuing the card issues a Statement of Account on a monthly basis to all card holders.
This Statement lists all payments authorized for purchases and credits made by the cardholder and
billed by merchants.
A purchasing professional administrative manager generally serves as the focal point for
coordination of the applications, issuance and destruction of cards, establishment of reports, and
administrative training.
The purchasing organization's Finance Office makes payment for the approving officials' certified
monthly statements.
A legally trained individual within the purchasing organization is generally assigned to coordinate,
process and monitor all disputed purchases, credits or billing errors.
Someone within the purchasing department (sometimes the cognizant purchasing professional
responsible for setting up the agreement with the bank) acts as liaison between the purchasing
organization and the issuing bank. This person oversees the credit card program and establishes
guidelines. Changes to dollar limitations or authorized merchant codes are generally approved
by this individual.

Policies Appropriate for Use of Credit Cards
The credit card should be used to pay for low dollar value purchases made in accordance with
Standard Purchasing Practices. It should primarily be used to pay for supplies or services
acquired using oral solicitation procedures. It may also be used to pay for supplies or services
that are acquired through a purchase order or written contract. Without exception, the credit
card may only be used to pay for authorized purchases. Generally the credit card should not be
used for cash advances.
The Purchasing Manager should delegate authority to make purchases up to a given amount per
transaction to be paid for using the credit card to individuals that have a need for the authority.
Individuals that have not taken formal purchasing training courses should receive
orientation/training on low dollar value purchasing. These individuals should also receive
procurement ethics training.
When the account information is submitted to the purchasing professional administrative

manager contact, a signature card should be completed that states the approving official may
certify credit card invoices for payment. The signature card should be forwarded to the Finance
Office after completion. An alternate approving official should be designated to avoid statement
processing delays and late payment penalties.
Electronic Ordering
This method requires the purchasing professional to place an order electronically with a supplier
(using some form of Electronic Data Interchange (EDI)). Many larger suppliers have the
capability of accommodating this form of purchasing. Fax transmissions are increasingly being
used both in the solicitation and ordering processes.
Use of Consignments
This method requires the purchasing professional to place an order to cover materials and
supplies physically located on the purchasing professional's premises. Under this method, the
purchasing organization draws from the supplier-maintained and owned inventory. The supplier
verifies withdrawals and bills the purchasing professional on some regular schedule. This is an
increasingly popular procurement method.
Purchase Order Drafts
This method requires the purchasing professional to use a combination purchase order and blank
check. The supplier completes the blank check, which is limited to relatively low dollar
amounts and sends it to the designated bank for processing and payment. Drafts (sometimes
called warrants) are very popular in public school districts for payment of employees.

Procurement Methods Generally Employed for Higher Dollar Value (and More Complex)
Purchases
Most organizations employ a combination of the following procurement methods for higher
dollar value purchases from commercial sources:
(1) Competitive Bidding
(2) Negotiation
Although these are the two basic procurement methods, there are modifications or adaptations of
these two. These modifications either relate to use of "hybrid" methods or relate to the
instrument or ordering mechanism which results from the competitive bidding or negotiation
processes. "Hybrid" methods would include:
(1) Two-step Bidding
(2) Sealed Bidding/Formal Advertising
Methods which relate to the instrument used or the ordering mechanism would include:
(1) Systems Contracting
(2) Contracts for "Just-in-Time"
(3) Use of "Standing Orders"
(4) Use of Vendor Managed Inventory(VMI)
Competitive Bidding
Competitive Bidding is the most widely used method of procurement for larger value purchases
in commercial and industrial settings. In the Federal Sector and in some states, the method is
referred to as "Competitive Proposals". The method contemplates the seeking of competition
(either on a full and open basis) or among firms that are considered "preferred", "partnered",
"certified", or "prequalified" suppliers. Restriction of competition to the latter four categories is
very common among commercial and industrial organizations. For most private entities,
competitive bidding (almost always without a public opening), is the preferred procurement
method. Firm-fixed-price purchasing with the lowest responsive and responsible bidder is
attempted and often achieved. Some firms and industries know no other way of purchasing.
This is particularly true of the construction business, where a firm-fixed-price contract with the
lowest responsive, responsible bidder after competitive bidding is the normal procurement
method.
Competitive bidding is generally appropriate whenever there is expected to be adequate

competition on the procurement; when there is sufficient time for the solicitation, evaluation, and
award processes; when the description of requirements is sufficiently definite to allow offerors to

bid without a great deal of pricing contingency; and when the decision to award a fixed price
contract can be readily arrived at based upon prices submitted and price-related factors.

Negotiation
Some purchasing situations, however, provide more opportunity and present significant
challenges, making it appropriate and/or necessary to deviate from the strict firm-fixed-price
competitive bidding mode of selection and to engage in some degree of negotiation, either on
technical qualifications, cost of performance, or both. When the organization desires to award a
contract to the supplier with the highest affordable technical quality, but that desired quality
cannot be defined in the statement of requirements, use of a "Best Value" evaluation approach
must be employed. This permits the organization to request technical (and other) proposals,
from which the level of quality can be inferred.
In many procurements, it is highly appropriate to use a logical mix of technical/management and

price/cost/business evaluation criteria in selecting a firm. Typically, the more technical the work,
the more weight that is given to the technical criteria. Procurements of research and
development services, for example, often warrant consideration of price/cost only if offerors are
otherwise equally technically qualified (as a "tie-breaker"). Consultants are almost always
selected on technical qualifications (as long as the rate of compensation doesn't exceed pre-
established policy parameters).
Two Step (Bidding)
Two-step bidding is considered a "hybrid" method of procurement because it contemplates

technical negotiations followed by a price competitive selection similar to the process used in
competitive bidding. In the first step, the purchasing professional solicits technical proposals
(only) from potential suppliers. A purchasing professional team evaluates the technical
proposals, conducts technical negotiations as necessary, and then places the proposals in three
categories:
(1) Acceptable
(2) Subject to Being Made Acceptable
(3) Unacceptable
The second step is to solicit priced offers (no cost proposals required) from the firms which have
submitted technical proposals in either of the first two categories. The award decision is then
similar to the decision made in competitive bidding (i.e., the lowest, responsive, responsible firm
normally gets the award.
Sealed Bidding/Formal Advertising
This is a "hybrid" method of procurement because it is an adaptation of competitive bidding. In

addition to following the normal rules for competitive bidding, a public bid opening is held and
firm, strict rules are followed on acceptance and evaluation of bids. Because it is so rigid and
inflexible (no negotiations or discussions are permitted), this method is used almost exclusively
in the public (government) sector.

Systems Contracting
This method relates to the ordering mechanism employed during the life of the contract. It is
often used in manufacturing environments for ordering or MRO materials. It contemplates a
high degree of cooperation between the purchasing professional and supplier facilitating a
reduction in inventory for both the purchasing professional and supplier. Ordering is
accomplished by designated purchasing organization personnel using an order release form so
designed as to permit the supplier to use the form for stock picking and order assembly. The
form normally contains instructions for routing and delivery. The method contemplates sharing
purchasing organization usage estimates and schedules to the supplier so that, in an ideal
condition, the method acts similar to "stockless purchasing". This type of contract is similar to a
"requirements" or other indefinite delivery type contract (see the discussion on types of contracts).
Contracts for “Just-in-Time”
Another method which relates to the ordering mechanism employed would contemplate a contract
providing for "Just-in-Time" ordering. This is similar to systems contracting with one major
difference. The primary focus here is on manufacturing materials and components as opposed to
MRO items. Because there has been so much written about just-in-time, we shall not explore
the concept in depth. Use of this method provides reduced inventory investment, reduced
warehouse space, better inventory turnover, purchase savings in lower prices, and paperwork
simplification.
Use of “Standing Orders”
An additional instrument used to facilitate ordering is a "standing order". Such an instrument

normally is negotiated and contains fixed prices during the ordering period. It is sometimes
called "open-ended ordering" and, like the systems contract, is similar to a "requirements" or
other indefinite delivery or blanket order type contract.

Use of Vendor Managed Inventory (VMI)
Introduction
The goal of Vendor Managed Inventory is to provide a mutually beneficial relationship where
both sides will be able to more smoothly and accurately control the availability and flow of goods.
In VMI a manufacturer or distributor assumes the role of inventory planning for the customer.
Extensive information sharing is required so that the manufacturer/distributor can maintain a high
degree of visibility of its goods at the customer‘s location. Instead of the customer reordering
when its supply has been exhausted, the supplier is responsible for replenishing and stocking the
customer at appropriate levels. Wal-Mart has mastered VMI and is the company against which
many other organizations benchmark themselves.
Customer Benefits
When the supplier can see that its customer is about to exhaust its inventory, the supplier can
better prepare to replenish the customer because the supplier can then better schedule its own
production/distribution. Customers will reduce/eliminate stockouts because they will not have to
reorder goods at the last minute without knowing whether the supplier has the ability to restock
without interrupting the customer‘s operations. Therefore, part of VMI‘s goal is to reduce
uncertainty that arises when the supplier is blind to the customer‘s inventory status.
Supplier Benefits
As long as the supplier carries out its task of maintaining predetermined inventory and avoiding
stockouts, it will be able to lock in a VMI-supported customer for the long term with or without a
contract. This will produce a steady and predictable flow of income for the supplier and reduce
the risk that the customer will switch suppliers (Switching would be too costly for the customer).
A VMI arrangement will allow the supplier to schedule its operations more productively because
it is now monitoring its customer‘s inventory on a regular basis. Furthermore, reductions in
inventory will be achieved once the supplier develops a better understanding of how the customer
uses its goods over the course of a year.
How to make VMI work

1. Clarify expectations. There needs to be thorough discussion about how the system will benefit
both organizations in the long term or one of the parties, particularly the supplier, is prone to
disappointment with some of the short-term results. If these items are not addressed the program
will likely be terminated quickly with neither side gaining any of the benefits expected from the
program. The objective is clear and constant communication between the supplier and customer.
When the two parties work in conjunction they can be assured that the planning function, for both
sides, will begin to smooth over time.
2. Agree on how to share information. If the supplier and customer can agree to share information
vital to restocking in a timely manner, then the odds of a synchronized system will dramatically
improve. Proprietary information would not have to be shared between the supplier and customer,
but enough information to maintain a steady flow of goods is necessary. The customer should be
willing to share production schedules and/or forecasts to provide some visibility for the supplier.
3. Keep communication channels open. When the two parties set out to implement a VMI
program, they need to meet and discuss their goals and how they need to proceed in order to

realize those goals. Once a VMI program has been activated, each side needs to understand that
there are going to be some miscues. These miscues need to be studied as opportunities for
learning and then used to avoid repetitive problems in the future.
Common Mistakes
Unexpected demand changes by the customer need to be shared with the supplier. Changes in
demand could result from the customer acquiring a new, large customer opening of a great deal of
stores in a short period; or offering special promotions that create spikes in demand. The supplier
may be unable to schedule production or shipment in a timely manner, causing a drop in
inventory available for the customer to sell in the event of a foreseen increase in demand. A spike
in demand could also create a burden on the supplier, who will have to reprioritize its production
plan or inventory from one customer to another. Likewise, if the supplier is experiencing a
significant spike in demand from a major customer, it may be wise to let the VMI customer, and
other customers as well, know that the supplier will have very little flexibility over a certain
period of time, so that everyone can adjust accordingly.
The most common cause of VMI failure revolves around communication breakdowns. All of
these problems in implementing a VMI program can be significantly diminished if they are
adequately addressed at the beginning of discussions. Hence, there should be several in-depth
meetings upfront to avoid problems down the road.
Developments
VMI is a stepping-stone toward an emerging process, Jointly Managed Inventory. In Jointly
Managed Inventory a partnership between the supplier and customer is formed. This solidifies the
current VMI relationship.
Jointly Managed Inventory (JMI) is a much more detailed extension of VMI but the goals and
premise are quite similar. It takes the foundation from which the relationship has already been
built and fine-tunes it. This partnership involves increased tactical planning between the supplier
and customer when developing JMI. This should include, but is not limited to, the customer
integrating the supplier into the customer‘s point-of-sales (POS) system, for example.
This integration allows the supplier to gain insight into real-time sales data to further improve the
replenishing function while being able to better plan its own production/distribution system to
meet the customer‘s needs. Proceeding to this step will further solidify the relationship and
produce a favorable outcome for each party.

Types of Contracts
Types of contracts that are available are explained below. Some general rules on types of
contract are indicated below.
GENERAL RULES ON TYPES OF CONTRACTS
 Although cost reimbursement and incentive contracts are available for use on many contracts,
the most common types of contracts used are firm-fixed-price, indefinite-delivery type, and time-
and-materials/labor hour (or a combination of these)
 The cost-plus percentage-of-cost type of contract should not be used.
 The firm-fixed-price type of contract shall be used whenever practical, and the purchasing
professional should state the reason(s) include in his/her negotiation memorandum for selecting a
contract type other than firm-fixed-price.

Fixed-Price Family of Contracts
Firm-Fixed-Price
A firm-fixed-price contract provides for a price that is not subject to any adjustment on the basis
of the supplier's cost experience in performing the contract. This contract type places upon the
supplier full risk and full responsibility for all costs and resulting profit or loss. It provides
maximum incentive for the supplier to control costs and perform effectively and imposes a
minimum administrative burden upon the purchasing professional.
A firm-fixed-price contract is suitable for acquiring commercial products or commercial-type

products or for acquiring other supplies or services on the basis of reasonably definitive
functional or detailed specifications when fair and reasonable prices can be established at the
outset.
Fixed-Price With Economic Price Adjustment/Escalation
A fixed-price contract with economic price adjustment provides for upward and downward
revision of the stated contract price upon the occurrence of specified contingencies. Economic
price adjustments are of three general types:
1. Adjustments based on established prices.

These price adjustments are based on increases or decreases from an agreed-upon level in
published or otherwise established prices of specific items or the contract end items.
2. Adjustments based on actual costs of labor or material.
These price adjustments are based on increases or decreases in specified costs of labor or material
that the supplier actually experiences during contract performance.
3. Adjustments based on cost indexes of labor or material.
These price adjustments are based on increases or decreases in labor or material cost standards or
indexes that are specifically identified in the contract.
A fixed-price contract with economic price adjustment may be used when:
1. There is serious doubt concerning the stability of market or labor conditions that will exist
during an extended period of contract performance; and
2. Contingencies that would otherwise be included in the contract price can be identified and
covered separately in the contract. Price adjustments based on established prices should
normally be restricted to industry wide contingencies. Price adjustments based on labor and
material costs should be limited to contingencies beyond the supplier's control.
A fixed-price contract with economic price adjustment should not be used unless it is necessary
either to protect the supplier and the purchasing professional against significant fluctuations in
labor or material costs or to provide for contract price adjustment in the event of changes in the
supplier's established prices.

Fixed-Price Incentive
A fixed-price incentive contract is a fixed-price instrument that provides for adjusting profit and
establishing the final contract price by application of a formula based on cost as accrued and
normally performance factors. The negotiated contract parameters include a target cost, target
fee (profit), share formula, and ceiling price.
A fixed-price incentive contract is appropriate when:
1. A firm-fixed-price contract is not suitable;

2. The nature of the supplies or services being acquired and other circumstances of the
procurement are such that the supplier's assumption of a degree of cost responsibility will provide
a positive profit incentive for effective cost control and performance; and
3. If the contract also includes incentives on technical performance and/or delivery, the
performance requirements provide a reasonable opportunity for the incentives to have a
meaningful impact on the supplier's management of the work.
A fixed-price incentive contract should be used only when:
1. This contract type is likely to be less costly than any other type;
2. It is impractical to obtain supplies or services of the kind or quality required without the use of
this contract type;
3. The supplier's accounting system is adequate for providing data to support negotiation of final
cost and incentive price revision; and
4. Adequate cost information for establishing reasonable firm targets is available at the time of
initial contract negotiation.
Indefinite-Delivery (Blanket Order) Type
Indefinite-delivery type contracts are often called "open end" or "term" contracts. They are quite
frequently employed in service and supply contracts, either in pure form or in combination with
other types such as firm-fixed-price and time-and-materials or labor-hour. There are three basic
forms of indefinite-delivery type contracts, including requirements contracts, indefinite-quantity
indefinite delivery, and definite-quantity indefinite delivery. Since the first two are more
commonly used, let's explore these two in some detail.
Indefinite Quantity-Indefinite Delivery (IQID) Contracts
The IQID establishes firm fixed unit prices for the units of work sought by the purchasing
professional. It states a guaranteed minimum quantity (base amount) and an estimated
maximum quantity (ceiling or cap). This contract type is utilized when the purchasing
professional is seeking supplies or services that requires high mobilization or start-up costs which
would not be recoverable if only a small percentage of the total estimated services were actually
ordered. The base amount should be more than just a nominal quantity, but should not exceed
the total amount the purchasing professional feels certain will be needed. This base provides the
supplier with a minimum upon which to offer, thus providing a means to recover costs of
mobilization or start-up.

IQID contracts provide the purchasing professional with certain benefits. Should the supplier's
performance be poor, the supplier may be paid for the guaranteed minimum and the contract
closed. A new solicitation and subsequent contract for the supplies or services can then be
issued. The purchasing professional should be aware, however, that in a new solicitation, there
is no guarantee that the same supplier will not be the lowest offeror.
When an IQID contract is awarded, the purchasing professional is generally authorized to order
any number of units to the maximum amount estimated for each work item in the schedule. The
supplier is then responsible for supplying the minimum quantities and additional quantities up to
that maximum. If the purchasing professional fails to order the base amount, the supplier must
still be paid the minimum amount guaranteed by the contract.
Funds for this type of contract are obligated only for the amount guaranteed at the time of award.
The balance of the funds for the units of work in excess of the base are obligated through delivery
orders as the items or services are procured by the purchasing professional.
Requirements
The requirements contract establishes firm fixed unit prices for the units of work sought by the
purchasing professional. This type contract provides that quantities stated in the schedule are
estimated and are not determined by the contract award. This type contract further provides that
the stated quantities are used only for the purpose of evaluating offers and determining the low
offeror. Offerors are put on notice that all or none of the work may be ordered. This type
contract also provides that the contract is guaranteed that if any contract work listed in the
schedule is needed during the term of the contract, such will be procured from this supplier This
procurement guarantee excludes performance of such work by the purchasing professional in-
house forces unless the contract contains a provision that under specified circumstances the
purchasing professional reserves the right to use in-house employees. Such reservations must be
very explicit.
The solicitation package for a requirements contract must clearly state that estimated quantities
shown are solely for offering and offer evaluation purposes. The solicitation documents include
a reasonable maximum ceiling or cap that may be ordered overall and limits any delivery order
amount and number of delivery orders at any one time under the contract. This cap or ceiling
protects the supplier from being inundated by an unanticipated workload and allows the
purchasing professional to solicit for large jobs separately.
The requirements contract does not obligate funds at the time of contract award. Obligation of
funds occurs upon issuance of a delivery order. When the need for the item or service is
required, a delivery order is written pursuant to the terms of the contract..
The requirements type contract does not provide the supplier with any insight of how to gear up
for the work; it only provides an estimate on which to base minimum levels of personnel,
supplies and equipment. As a result of the unknowns associated with this type of contract, its
use may attract few offerors.

Blanket Agreement
A blanket agreement is a written instrument of understanding that contains:
1. Terms and conditions applying to future orders (calls) between the parties during its term;
2. A description, as specific as practicable, of supplies or services to be provided; and
3. Methods of pricing, issuing, and delivering future orders (calls) under the blanket order.
A blanket agreement is not a contract. Blanket agreements may be used if there is a wide variety
of items in a broad class of services or goods that are generally purchased but the exact items,
quantities, and delivery requirements are not known in advance and may vary considerably, or in
any other case in which the writing of numerous procurement orders can be avoided through the
use of this procedure. A ceiling must be established for the total instrument as well as for each
order (call).
Cost Reimbursement/Reimbursable Family of Contracts
General Guidance on Use
These types of contracts are suitable for use only when uncertainties involved in contract
performance do not permit costs to be estimated with sufficient accuracy to use any type of fixed-
price contract. They are particularly appropriate for research or preliminary exploration or study
where the level of effort required is unknown and for development and testing.
A cost reimbursement contract provides for payment of allowable incurred costs, to the extent
prescribed in the contract. These contracts establish an estimate of total cost for the purpose of
obligating funds determining the fixed fee, and establishing a ceiling that the supplier may not
exceed (except at its own risk) without a modification to the contract.
Cost reimbursement contracts should be used only when the supplier's accounting system is
adequate for determining costs applicable to the contract; when appropriate surveillance during
performance will provide reasonable assurance that efficient methods and effective cost controls
are used; and when this particular type of contract is likely to be less costly than any other type or
it is impractical to obtain supplies or services of the kind or quality required without the use of
this contract type.
Cost With No Fee and Cost Sharing With No Fee
These are cost-reimbursement contracts in which the supplier receives no fee. They may be
appropriate for research and development services, particularly with non-profit educational
institutions or other non-profit organizations, and for facilities contracts. In cost contracts, the
purchasing organization reimburses the supplier all reasonable, allocable, and allowable costs.
In cost sharing contracts, the purchasing organization splits the total costs in some way (50-50,
direct-indirect, or by phase).
Cost-Plus-Fixed Fee

A cost-plus-fixed fee contract is a cost-reimbursement contract that provides for payment to the
supplier of a negotiated fee that is fixed (in dollar amount) at the inception of the contract. The
fixed fee does not vary with actual cost, but may be adjusted as a result of the changes in the work
to be performed under the contract under the changes article or other mechanism specifically set
forth in the contract.
Cost-Plus-Incentive-Fee
A cost-plus-incentive-fee contract provides for a target cost, a target fee, a minimum and
maximum fee, and a fee adjustment formula.
Under this type of contract, the purchasing professional reimburses the supplier for all actual
allowable costs. Then, the purchasing professional applies the fee adjustment formula. Under
the formula, if the actual allowable costs exceed the target costs, the supplier's fee is less than the
target fee and vice versa. In other words, the lower the supplier's costs, the higher the supplier's
fee. Regardless of cost incurrence, the contract will not earn more than the maximum fee or less
than the minimum fee. Performance incentives may be applied to the contract arrangement to
supplement the cost incentive, if appropriate.
The cost-plus-incentive-fee contract is suitable for use in development and test programs when
cost (and performance) incentives are likely to motivate the supplier.
Cost-Plus-Award Fee
The cost-plus-award-fee contract is a cost-reimbursement contract that provides for a fee

consisting of:
1. A base amount fixed at inception of the contract; and

2. An award amount that the supplier may earn in whole or in part during performance and that is
sufficient to provide motivation for excellence in such areas as quality, timeliness, technical
ingenuity, and cost-effective management.
The amount of the award fee to be paid is determined by the supplier's performance in terms of
the criteria stated in the contract. Criteria are generally of a subjective nature.
The cost-plus-award-fee contract is suitable for use when:
1. The work to be performed is such that it is neither feasible nor effective to devise
predetermined objective incentive targets applicable to cost, technical performance, or schedule;
2. The likelihood of meeting a purchasing objective will be enhanced by using a contract that
effectively motivates the supplier toward exceptional performance and provides the purchasing
professional with the flexibility to evaluate both actual performance and the conditions under
which it was
3. Any additional administrative effort and cost required to monitor and evaluate performance are
justified by the expected benefits.

“Hybrid” Contracts
Time-and-Materials
This type of contract is commonly used in purchasing.
A time-and-materials contract provides for acquiring supplies or services on the basis of:
1. Direct labor hours at specified fixed hourly rates that include wages, overhead, general and
administrative expenses, and profit; and
2. Materials at cost, including, if appropriate, material handling costs as part of material costs.
A time-and-materials contract should be used when it is not possible at the time of placing the
contract to estimate accurately the extent or duration of the work or to anticipate costs with any
reasonable degree of confidence.
A time-and-materials contract should be used:
1. Only when no other contract type is suitable; and

2. Only if the contract includes the establishment of a separate ceiling amount for labor, beyond
which the fixed hourly rates specified in the contract will be reduced by deleting the profit
included therein (in order to avoid a cost-plus-a-percentage-of-cost situation).
Labor-Hour
Labor-hour contracts are a variation of the time-and-materials contract, differing only in that
materials are not supplied by the supplier or, if they are supplied, their cost is included in the
loaded hourly rate.
Combination Contracts
The purchasing professional will be confronted with many situations which call for a flexible
approach to structuring contracts. Many functions require consideration of combination or
composite contract-type thinking. It is not uncommon to be confronted with a situation which
requires consideration of a combination firm-fixed-price/requirements/time-and-materials
contract, particularly where a contract must, of necessity, incorporate both service and
construction work.
Combination/composite contract thinking has logically spread into the supply and service
contract business in general. Many purchasing situations call for work "as needed", which
essentially means the contract needs an indefinite-delivery type and/or time-and-materials/labor-
hour type schedule of "on call" requirements (often in conjunction with firm-fixed-price work).
The combining of contract types in a single contract document for associated services is practical
because it reduces the number of formal solicitation packages that have to be prepared, the

solicitation effort, and the resulting contract documents. For instance, one contract can contain a
combination of a firm-fixed price and time-and-materials work.

Letter Contract
A letter contract is a written preliminary contractual instrument that authorizes the supplier to
begin immediately performing work. Their use should be strictly discouraged.
Contract Evaluation and Analysis
Evaluation and Analysis-Low Dollar Value (Small) Purchases
The evaluation and analysis process is considerable less complex for low dollar value purchases
than it is for larger complex contracts. Because of that, we shall devote our first discussion to
the process of evaluating those lower dollar value purchases.
Purchases using ―low dollar value procedures" may use factors other than price as the deciding
factor in award. These purchases do not require the use of explicitly stated technical evaluation
factors to determine which firm is in line for award. However, where awarding to other than the
low quoter, the purchasing professional should document the file as to the reason for not
awarding to the low quoter. This is particularly appropriate for situations where the low quoter
is determined to be a nonresponsible firm by virtue of demonstrated poor past performance or
inability to satisfy other contractor responsibility standards.
Factors to Consider
The purchasing professional should evaluate the quotations received in order to determine which
quotation represents the most favorable buy. The critical determining factor often is price.
Nevertheless, other factors do come into play.
In many purchases, the purchasing professional must analyze the operation of such quantitative
factors as discounts, all-or-none qualifications, and transportation charges in determining the
lowest evaluated price to the purchasing organization. Various adjustments to prices may need
to be made, singly or in combination.
Generally, quotations may be evaluated using a number of criteria in addition to price. These
criteria are shown below
Evaluation Factors in Addition to Price for Low Value Purchases
1. Relative quality and adaptability of supplies or services;
2. Supplier's financial responsibility;
3. Supplier's skill;
4. Supplier's experience;
5. Supplier's record of integrity in dealing;

6. Supplier's ability to furnish repairs and maintenance;
7. Time of debriefing or performance offered;
8. Compliance with specifications.
This flexibility permits the purchasing professional to award to other than the lowest supplier.
However, when doing so, the reason why award does not go to the low supplier must be
documented on an abstract of bids.
Awards may only be made to responsible suppliers. Responsibility factors to be considered

include any or all of the criteria above.
For many purchases, it is necessary to negotiate before issuing the purchase order to make sure
that the purchasing professional obtains the best deal available. Guidelines for conducting
negotiations are presented later in this text.
For all but the most straightforward purchases, preparation of an abstract or matrix of the
quotations facilitates the evaluation process.
Pricing for Low Value Purchases
If low dollar value purchasing procedures and approaches to pricing are to be effective, all
persons involved must demonstrate ability to use pricing judgment and discretion in exercising
their authority. Because of the simplified procedures for small purchases, authority and
responsibility are delegated to a greater number of people. These personnel may make the
ultimate decision to buy, sometimes while talking to the supplier on the phone. Their actions
must be based on sound judgment so that the best buys, price and other factors considered, can be
made.
All purchasing professionals have an obligation to procure at fair and reasonable prices. The
terms ―fair‖ and ―reasonable‖ signify that a price is acceptable to both the purchaser and the seller.
Whether the price paid is in fact fair and reasonable will depend on the effectiveness of the
purchasing professional in evaluating quotations and reaching a conclusion. To be effective, the
purchasing professional must develop a working knowledge of the products being bought and the
industries being dealt with. This knowledge will facilitate decisions as to the fairness and
reasonableness of the prices to be paid.
Different Conditions Require Different Analytical Methods
The conclusion that a price is fair and reasonable must be based on some form of price and/or
cost analysis. How detailed this analysis will be depends on the dollar value and the nature of
the product or service being purchased.

Price Analysis
Both Dobler and Burt (1996) and Graw (1994) assert that "Some form of price analysis is
required for every purchase." Although this is true, price analysis takes on special importance
when it is employed by itself (without the use of cost analysis). Price analysis is generally used
without cost analysis for low dollar purchases; for most competitive purchases, even though of a
large dollar value; for purchases based upon existing catalog or market prices; and for purchases
of items or services for which regulated prices exist (regulated utility services).
Basis for Comparison
To perform price analysis, the purchasing professional must have a base or reference to which the
quoted price can be compared. That basis for comparison must itself be known to be reasonable.
Then the purchasing professional must ensure that the quotation and the base are truly
comparable and that the comparison is not being made between apples and oranges. That is why
the comparison of competitive quotations is such an effective method of price analysis. If the
purchasing professional can be reasonably assured that the items are comparable and, presuming
that the firms involved are really competing with one another, then the lowest price submitted
will be reasonable.
In performing price analysis, comparability is the key. One must consider:
 quality of the items for which prices are being compared;

 quantities involved in the sale;
 delivery conditions (f.o.b. origin versus f.o.b. destination);
 market conditions (for some items, tomorrow's price may be different from yesterday's, often
by a wide margin).
If the purchasing professional can arrive at a reasonable base for comparison, even though it
includes adjustments for differences in relation to some of the items listed above, the use of price
analysis techniques will determine whether a price is fair and reasonable.
Methods of Price Analysis
Many methods of price analysis are available. Selection of the method to use depends on the
specific features of the acquisition situation. In many instances, a combination of methods is
best. The following methods are among the most commonly used:
Comparison With Competing Offers on the Instant Procurement
This is generally considered a primary method of price analysis. It is nothing more than the act
of seeing what price quoted is the lowest among those received. Unless there is some doubt
about the adequacy of competition, this method is generally considered a conclusive judge of
price reasonableness. The purchasing professional must be sure, however, that the prices
compared are submitted on the same basis and that factors such as transportation charges to be
paid by the purchasing professional (when delivery is to be f.o.b. origin) have been considered.
See the discussion below with respect to placing offers on the same basis.

Comparison With Established Catalog Prices
In the absence of price competition this method of price analysis should be considered a primary
method of comparison. The method is supported by the fact many suppliers publish prices for
items which are regularly offered for sale. Quotations can be compared to those published
prices, but caution is required. First, the purchasing professional must make sure that the
catalogs represent actual prices which are now or were recently being charged. (Catalog prices are
frequently discounted for Government agencies and large corporations, which are generally
considered "most favored customers" because of the large volume of business they engage in).
Second, the purchasing professional must be sure that the price listed applies to an item which is
sufficiently similar to the required item to provide a sound basis for comparison. Third, the
purchasing professional must be sure that the catalog or price list applies to the same class of
trade. If one item at a time is being purchased, comparison to the Sears or Montgomery Ward
catalog price is indicated. But if the purchase is for wholesale quantities, the Sears or Wards
prices are not indicative since they do not reflect normal trade or quantity discounts.
Comparison With Established Market Prices
Like the comparison with established catalog prices, this method of price analysis should be
considered a primary method in the absence of price competition. Many items are regularly
traded at prices which tend to fluctuate over short intervals. Catalogs of prices for these items
are not published because changes occur too rapidly. But if the purchasing professional can
establish the price range in which sales are being made to the general public (through trade
journals or other sources), that range can be used as a basis for comparison.
Comparison With Prices Set By Law or Regulation
This is another primary method of price analysis which is appropriate when dealing with
regulated utility services. Regulated utilities (electric companies and the like) are required to
seek the approval of their regulatory commission before they can adjust their rates. These public
regulatory commissions are zealous of the consumer interest and grant increases in rates rather
sparingly. If the purchasing professional is buying regulated services, the regulatory
commission approved rates will be published and available to the purchasing professional. The
purchasing professional, however, must be assured of the fact that the classification being used by
the utility is correct. Many electricity tariffs (rate schedules) will have different rates for heavy
and light users; for commercial, industrial, and governmental users; and for non-profit users.
The purchasing professional must assure the lowest rate available to the purchasing professional's
specific situation is the one applied. In addition, the purchasing professional must recognize
that his organization may have an opportunity to impact the rates through the process of
"intervention" at the public utility hearings. He should recognize further his organization may
be able to establish a rate category specific to his organization's circumstances. These
opportunities should be explored if appropriate.

Comparison With Current Prices Paid for the Same or Similar Items, Past Prices Paid for
the Same or Similar Requirement, and Past Offers
This method of price analysis should be considered only after one or more of the primary methods
discussed above has been attempted. If the price quoted is the same or less than that which was
recently paid for the same or similar items, the current quotation is likely to be reasonable.
Purchasing professionals should be careful, however, to ascertain that the historical prices to
which a comparison is made were themselves adequately analyzed for reasonableness. Further,
they should take into account price trends (up or down) caused by market or economic conditions,
rapidly fluctuating commodity prices, or other factors. Often the purchasing professional will
have a basis for comparison in the form of prices for an item that is similar but not identical to the
one being bought. If the purchasing professional can, through some method of price analysis,
determine what the difference in price should be between the item being purchased and the one
for which prices are available, that difference can be used as an adjustment in order to arrive at a
valid comparison. Price history information can be obtained from the records of the Contracting
or Purchasing Department, the requisitioning activity, or if necessary, from other contacting
organizations. The purchasing professional must be sure the price history applies to the same
item under similar conditions.
Comparison With Producer Price and Other Market Indexes
This technique, although it is generally considered a secondary method of price analysis, is very
powerful and should be considered for use even when other more obvious comparative methods
are available. This method is often used in conjunction with the method discussed immediately
above in order to make prices from different points in time comparable with respect to a specific
point in time. There are numerous indexes available to the purchasing professional for use in
the following analytical procedures:
 Adjusting previous prices for the effects of inflation from the purchase date to the present.
 Adjusting current prices for the effects of inflation from the present to the previous purchase
date.
 Extrapolating current prices into the future based upon the assumption future price increases
will mirror the past. This is generally done through forecasting of index numbers.
 Comparing prices paid in two successive contracts with increases in market prices during the
same period.
 Comparing price increases in one commodity against price increases in another commodity
during the same time period.
 Comparing general growth in prices (Consumer Price Index) with growth of specific items or
commodities (Producer Price Index).
Sources of Indexes
Although the Consumer Price Index and the Producer Price Index (both monthly publications
available from the U.S. Department of Labor Bureau of Labor Statistics (BLS)) are the two most
commonly used indexes in price and cost analysis, there are several other publications which may
be of interest to buyers. The BLS also publishes wage and benefit changes resulting from
collective bargaining settlements and unilateral management decisions, statistical summaries, and
special reports on wage trends in its monthly publication entitled "Current Wage Developments"

in addition to articles on labor force, wages, prices, productivity, economic growth, and
occupational injuries and illness in its monthly publication entitled "Monthly Labor Review".
Still other helpful BLS publications include the "Area Wage Surveys" published in 70 different
parts throughout the year. These surveys include office clerical, professional, technical,
maintenance, custodial, and material movement occupations. The U.S. Departments of
Commerce, Interior, and Energy also publish specialized information which may be helpful in
analyzing labor and material price trends. Many commercial and industrial publications have
helpful pricing information which can also be used to analyze labor and material trends. Many
of these are industry specific.
Comparison With Cost Estimating Relationships, to Include Rough Yardsticks and

Parametric Relationships
This comparison technique is considered by many to be a powerful secondary method of price

analysis. Cost estimating relationships are defined as relationships between cost and an item or
service characteristic. Typical cost estimating relationships include those included on the next
page.
COST ESTIMATING RELATIONSHIPS
 The cost of construction based upon floor space, roof surface area and/or wall surface;
 The cost of gears based upon gear net weight, percent of scrap produced by the gear, inches
of teeth cut into the gear, the hardness of the gear, and/or the envelope of the gear;
 The cost of trucks based upon truck empty weight, truck gross weight, horsepower, number
of driving axles, and/or loaded cruising speed;
 The cost of passenger cars based upon curb weight, width of wheel base, square feet of
passenger space, and/or horsepower;
 The cost of turbine engines based upon dry weight, maximum thrust, cruise thrust, specific
fuel consumption, bypass ratio and/or inlet temperature;
 The cost of reciprocating engines based upon dry weight, piston displacement, compression
ratio, and/or horsepower;
 The cost of sheet metal based upon net weight, percent of scrap, number of holes drilled,
number of rivets placed, inches of welding, and/or volume of envelope;
 The cost of aircraft based upon empty weight, speed, useful load, wing area, power, and/or
landing speed;
 The cost of diesel locomotives based upon horsepower, weight, cruising speed, and/or
maximum load on standard grade at standard speed.

Developing the Cost Estimating Relationship
The "and/or" in the explanations above suggest that cost estimating relationships can be based
upon more than one independent variable (the "based upon" factors). Although the simplest cost
estimating relationships are linear (indicating a straight line on a graph of the independent and
dependent variables), some relationships are curvilinear (other than a straight line). Such
relationships are best dealt with by using computers. Actually modern computer programs are
helpful in developing all types of cost estimating relationships and are even more important when
forecasting dependent variables (the "costs" indicated above which are "based upon" the
independent variables suggested.)
When developing a cost estimating relationship, it is necessary first to designate and define the
dependent variable (the factor that is influenced or caused by the independent variable). The
dependent variable is generally cost or manhours.
After designation of the dependent variable, one must select item characteristics to be tested for
estimating the independent variable. The independent variable is the factor that influences or
"drives" the dependent variable. Finding that independent variable is not always easy. The
purchasing professional will need to draw upon his/her personal experience, the experience of
others, and published information. In selecting the independent variable, the purchasing
professional should consider only factors which are (1) readily available in a statistically usable
form; (2) quantitatively measurable; (3) related to performance characteristics of the item or
system being explained by the cost estimating relationship.
After selection of the dependent and independent variables, the purchasing professional will need
to collect data concerning the relationship between the two. Data for at least five points (often
years) should be collected. The data should be checked to assure that it is relevant, comparable,
and free of unusual elements.
After collection of the data, the purchasing professional will need to examine the relationship
between the independent and dependent variables. This examination can be something as
simple as graphing the data to something as complex as running the data through a computer
regression analysis program. The purpose is to test the degree of relationship between the
variables. A high correlation coefficient between the variables usually indicates that the
independent variable will be a good predictive tool.
After examination of the relationship, the purchasing professional will need to determine the
relationship that best predicts the dependent variable. This generally requires testing more than
one independent variable against the dependent variable.
Once the best relationship is identified, the model or formula resulting from the effort is saved for
use as a forecasting tool.

Comparison With In-House Estimates
If the requisitioner has developed a competent cost estimate for the item or service to be acquired,
the quoted price can be compared with that estimate. Care should be exercised to ensure that the
estimate is a sound base for comparison which takes into account all factors which will affect the
price. The estimate should have been prepared when the PR was submitted, without knowledge
of the quotes received. The estimate is not to be based on the amount of program funds
available, but in consideration of the current market prices for the goods and services being
requisitioned. Detailed, "bottom-up" estimates are particularly important in purchasing of
services, particularly construction services. A detailed in-house estimate will be very helpful to
the construction purchasing professional for comparison with the low bidder's working papers
whenever there is some question about whether the low bidder has missed some work in his bid.
By doing a "side-by-side" comparison of the low bidder's working papers and the in-house
estimate, serious estimating errors can be discovered. The prudent course of action for the
purchasing professional in such an eventuality is to permit the low bidder to withdraw his bid and
proceed on to the next bidder (who would generally be subjected to a similar type of comparison.)
If, of course, the low bidder had bid in line with the in-house estimate, there would be no need for
a "side-by-side" comparison.
In-house estimates are also essential in performing cost analysis, particular in limited competition
situations. When a potential supplier submits a cost proposal in response to the solicitation, the
purchasing professional generally relies upon his own engineer's estimate of required manhours,
material quantities, and equipment quantities in analyzing the supplier's cost proposal. In many
cases, the labor rates, material prices, and equipment rates included in the in-house estimate are
good guides to follow also. Generally, however, these rates (and the accompanying indirect
rates) are subject to additional verification by purchasing professional and/or auditor review of
supplier books and records and/or market rate analysis.
Comparison With Prices Determined by Value and Visual Analysis
These techniques are generally considered tertiary or "auxiliary" price analysis techniques.
Value analysis is the task of determining why seemingly similar products should be price
differently. The technique helps the purchasing professional understand the reason for price
differences between past buys and present offers. Buyer value analysis generally concentrates
on utility and aesthetic qualities of similar items in order to derive opinions of respective value.
The analysis normally takes place in two stages. In the first stage the purchasing professional
lists the functions required and compares the required functions to those of alternative products.
In doing this, the purchasing professional assumes that an item with a lower use value should
have a lower price (an assumption which may not be supported in fact). In the second stage, the
purchasing professional identifies and compares the aesthetic functions to those of alternative
products. Upon completing the second stage, the purchasing professional often finds that the
price differentials, if any, are supported by the aesthetic differences rather than the use differences.
Commercial and industrial entities are generally more interested in use than aesthetic value.
Visual analysis is a simpler technique in that it involves visual inspection of the item (or
alternatively, the representations of the item in drawings), in order to develop a rough estimate of
the value. Because it concentrates on obvious, external features of an item, it should be used

only to get you "into the ballpark". However, it can prevent mistakes and oversights and lead to
questions about offered prices. The purchasing professional who bought the now infamous
"$600 Hammer" would probably have benefited from this analytical technique.
Evaluation Factors for Award of Multiple Contracts
When quotations are obtained on related items such as various supplies, small hardware items,
equipment parts, or office supplies, the purchasing professional may stipulate in the Request for
Quotations that the purchasing professional reserves the right to award on an all-or-none basis;
that is, the purchasing professional may purchase from the offeror who submits the lowest total
price for all items, rather than issue a purchase order to each supplier on the basis of the lowest
quotation on each item. Purchasing on the basis of lowest total cost may afford savings since
the cost of writing and administering multiple purchase orders and making multiple payments
may be rather expensive. At many organizations, the cost of issuing an order and paying the
invoice for a low value purchase is estimated at $100. (The Federal Government uses $500--
other organizations use factors falling between these two values).
This amount will be used as an evaluation factor when considering award of multiple orders from
a single RFQ.
EXAMPLE 1
In the following example, award in the aggregate should be made to Supplier B because that will
result in a total savings, even though B was not low on each item.
SUPPLIERS
Item No. A B C Low Quotation
1 $125 $130 $133 $125 (A)

2 $150 $144 $147 $144 (B)
3 $148 $143 $140 $140 (C)
Totals $423 $417 $420 $409
Cost to Issue $100 $300

Purchase Order(s)
Total Cost $517 $709
To determine whether purchases should be made based on lowest total cost, it is necessary to
ascertain the administrative cost of the method of purchase.
It may not always be advantageous to award "all or none" therefore, suppliers should be advised
that the purchasing professional reserves the right to award (or not award) on that basis after
evaluation of supplier quotations.

Prompt Payment Discounts
A prompt payment discount is a reduction in price on the condition that the purchasing
professional pays the bill within a certain number of days after receipt of an invoice. Prompt
payment discounts can be a significant source of savings.
It is often to the supplier's advantage to take a smaller payment quickly rather than wait for a few
extra dollars. Suppliers have to worry about their cash flow; they have to be sure to have money
on hand to pay their employees and to meet their obligations. Their accounts receivable, that is,
money owed to them, cannot be used to pay those bills; they have to have cash on hand or
deposits in the bank. If they do not have enough, they must often borrow and pay interest.
Also, if they do not receive payments, they may have to go through the process of issuing a
second invoice to ensure that the first one was received, which process of course costs money.
For these reasons, even large companies may offer a discount to customers who pay quickly.
Prompt payment discounts are generally stated as a percentage off the stated price if payment is
made within a certain number of days. The notice "2 percent, 20 days", means that if the invoice
is paid within 20 days of the date it is received, the customer may deduct 2 percent from the total.
On a $5,000 purchase, for example, a 2 percent discount means a savings of $100. Discounts
may be offered on a sliding scale: "2 percent, 20 days; 1 percent, 30 days."
When written solicitations are used, the purchasing professional should always check to see if the
supplier has offered a prompt payment discount. When oral quotations are received, the
purchasing professional should inquire about such discounts. The purchasing professional
should, under certain circumstances, solicit prompt payments discount but will not consider the
discount in the price evaluation.
Because the time needed to process payments exceeds 10 days, discounts of less than 20 days
should not be negotiated.
(Domestic) Transportation Terms
F.O.B. (Free On Board) point refers to the location at which the seller delivers the supplies or
materials to the purchasing professional. The seller owns the goods until they reach that point,
and has responsibility for shipment and damage to that point. At that point, the purchasing
professional takes ownership of the supplies or material, and is responsible for damage and costs
incurred after that point. The owner of the goods is responsible for determining and exercising
control over the shipment of the goods. There are three major types of f.o.b. points in common
use:
"F.O.B. Origin" means free of expense to the purchasing professional delivered on board the
indicated type of conveyance of the carrier (or of the purchasing professional, if specified) at a
designated point in the city, county, and state from which the shipment will be made and from
which line-haul transportation service (as distinguished from switching, local drayage, or other
terminal service) will begin.

When quotations have been requested on an F.O.B. Origin basis, the purchasing professional will
take possession of the item at the contractor's location, arrange for transportation, be responsible
for loss or damage in transit, and pay any freight charges involved in getting it to the point of
actual use. In such a case, the purchasing professional must determine the lowest applicable
freight charge between the supplier's location and the point of use.
When specifying F.O.B. shipping point, be sure to understand where that shipping point is. The
sales office could be in Seattle, but the plant and shipping point in Miami. Shipping costs could
then be much more expensive than anticipated. Freight rates can be obtained from the traffic
unit. This amount must then be added to the quoted price to arrive at a price for evaluation.
Obviously, the same procedure must be used for all supplier prices.
A variation is sometimes used which provides that the supplier transfers title to the purchasing
professional upon delivery of the goods to the carrier, but prepays the shipping costs and charges
the costs to the purchasing professional. The purchasing professional owns the goods during
shipment, and is responsible for loss or damage en route.
"F.O.B. Origin, Freight Allowed‖ means free of expense to the purchasing professional delivered
on board the indicated type or conveyance of the carrier (or of the purchasing professional, if
specified) at a designated point in the city, county, and state from which the shipments will be
made and from which line-haul transportation service (as distinguished from switching, local
drayage, or other terminal service) will begin; and an allowance for freight, based on applicable
published tariff rates (or Government rate tenders) between the points specified in the contract, is
deducted from the contract price. In this instance, title is transferred to the purchasing
professional when the seller delivers the goods to the carrier. The seller reimburses the
purchasing professional for the transportation costs. Responsibility for loss or damage during
transit is assigned to the purchasing professional.
F.O.B. Destination" means free of expense to the purchasing professional delivered on board the
carrier's conveyance, at a specified delivery point where the consignee's facility (plant, warehouse,
store, lot, or other location to which shipment can be made) is located; and supplies shall be
delivered to the destination consignee's wharf (if destination is a port city and supplies are for
export), warehouse unloading platform, or receiving dock, at the expense of the contractor. the
purchasing professional shall not be liable for any delivery, storage, demurrage, accessorial or
other charges involved before the actual delivery (or "constructive placement" as defined in
carrier tariffs) of the supplies to the destination, unless such charges are caused by an act or order
of the purchasing professional acting in its contractual capacity. If rail carrier is used, supplies
shall be delivered to the specified unloading platform of the consignee.
If motor carrier (including "Piggyback" is used, supplies shall be delivered to truck tailgate at the
unloading platform of the consignee. If the contractor uses rail carrier or freight forwarder for
less than carload shipments, the contractor shall ensure that the carrier will furnish tailgate
delivery if transfer to truck is required to complete delivery to consignee.
In this instance, ownership of the goods transfers to the purchasing professional when they are
delivered to the specified destination. The seller pays the transportation costs and is responsible

for loss or damage to the destination. This is the preferred method because the seller must
handle problems that occur before the goods are received by the purchasing professional.
When the F.O.B. point is at destination, an article which requests the supplier to "prepay and add"
freight costs is inappropriate and shall not be used.
Written Solicitations for Larger Value Purchases
Within the public sector, suppliers are generally selected on a sealed bid or formal advertising
basis. For most private entities, competitive proposals (almost always without a public opening),
is the preferred procurement method. In both the public and private sectors, firm-fixed-price
purchasing with the lowest responsive and responsible bidder is attempted and often achieved.
In the public arena, some industries and firms know no other way. This is particularly true of
the construction business, where a firm-fixed-price contract with the lowest responsive,
responsible bidder after sealed bidding/formal advertising is the preponderant procurement
method. Some purchasing situations, however, often provide more opportunity and present
significant challenges, making it appropriate and/or necessary to deviate from the strict firm-
fixed-price after advertising mode of selection. When the organization desires to award a
contract to the supplier with the highest affordable technical quality, but that desired quality
cannot be defined in the statement of requirements, use of a "Best Value" evaluation approach
must be employed. This permits the organization to request technical (and other) proposals,
from which the level of quality can be inferred.
Importance of Price/Cost as an Evaluation Factor
Although price/cost should always be a factor in selection of suppliers, the degree of importance
of price/cost as a factor should be open to rational and flexible treatment. Typically, in
procurement of architect-engineering (design) services, price/cost is considered only after
selection based on technical qualifications has been made. This is an industry-wide practice, but
can be deviated from if justified. Some firms have adopted a policy of considering price as well
as technical factors even in selection of architect-engineering contractors. In many other
procurements, it is highly appropriate to use a logical mix of technical/management and
price/cost/business evaluation criteria in selecting a firm. Typically, the more technical the work,
the more weight that is given to the technical criteria. Procurements of research and
development services, for example, often warrant consideration of price/cost only if offerors are
otherwise equally technically qualified (as a "tie-breaker"). Consultants are almost always
selected on technical qualifications (as long as the rate of compensation doesn't exceed pre-
established policy parameters).
Every procurement, irrespective of the procurement method used, must use price analysis as a
tool to determine whether or not the price is reasonable. Generally the purchasing professional
(without outside assistance) conducts the price analysis. In addition, the purchasing professional
should anticipate the potential need for cost data in those instances where price analysis alone
cannot assure fairness and reasonableness of price. When cost data is required on a specific
purchase, the purchasing professional must coordinate the cost analysis of the cost proposal or
cost data submitted by the supplier. In addition, the purchasing professional must, where

appropriate, use the results of the price and/or cost analysis in negotiating the price with the
supplier.

Cost Analysis
Inasmuch as we previously discussed price analysis, we shall direct our attentions to the second
analytical method of Cost Analysis.
Cost analysis is the review and evaluation of the separate cost elements and proposed profit/fee of
(a) an offeror's cost or pricing data, and (b) the judgmental factors applied in projecting from that
data to the estimated costs, in order to form an opinion on the degree to which the proposed costs
represent what the contract should cost, assuming reasonable economy and efficiency. It
includes the verification of cost data, and evaluation of cost elements, including all the elements
below.
ELEMENTS OF COST ANALYSIS
1. Determination of the necessity for and reasonableness of proposed costs.

2. Projection of the offeror's cost trends, on the basis of current and historical cost or pricing data.
3. A technical appraisal of the estimated labor, material, tooling and facilities requirements and
of the reasonableness of scrap and spoilage factors.
4. The application of audited or negotiated indirect cost rates, labor rates, or other factors.
Among the evaluations that should be made, where the necessary data are available, are
comparisons of an offeror's current estimated costs with:
(1) Actual costs previously incurred by the same contractor or offeror;

(2) Previous cost estimates from the offeror or from other offerors for the same or similar items.
(3) Other cost estimates received in response to the solicitation.
(4) Independent cost estimates by technical personnel.
(5) Forecasts of planned expenditures.
Cost Analysis NOT NEEDED When:
Cost analysis should not be employed when reasonableness of price can be established by:
(1) Adequate price competition;
(2) Established catalog or market prices of commercial items sold to the general public in
substantial quantities; or
(3) Prices set by law or regulation.

BEST VALUE/BUY EVALUATION PROCESS
When factors other than price/cost are included in the evaluation criteria for award, the
organization generally follows a 14 step process as shown below.
BEST VALUE/BUY EVALUATION PROCESS
1. An advance purchasing plan is developed..

2. A source selection plan is developed (see explanation below).
3. Offers are solicited using a written solicitation.
4. Technical/management and price/cost/business proposals are submitted.
5. Proposals are evaluated and scored (see discussion below).
6. A competitive range for negotiation is determined. If two or more proposals are fully
acceptable and price competition is present, award is made. If negotiations are required for
technical and/or cost reasons, the process continues.
7. If discussions are to be held, all offerors outside the competitive range are notified.
8. Offerors still within the competitive range are invited to discussions and advised of their
deficiencies.
9. Remaining offerors are invited to submit best and final offers (BAFOs).
10. A final evaluation is made and final scores determined.
11. The source selection official (normally the purchasing professional) is provided with the
results of the final evaluation.
12. The source selection official makes an award decision.
13. The purchasing professional awards a contract and notifies unsuccessfuls.
14. Unsuccessful offerors are briefed upon request.
SOURCE SELECTION PLAN
In conducting a "Best Value" source selection process, the purchasing professional team should
develop (on a team basis) a source selection plan that contains the items below.
CONTENTS OF THE SOURCE SELECTION PLAN
 The technical/management criteria/evaluation factors for award in their relative order of

importance. (These factors should be tailored to the procurement, and include only those factors
that will have an impact on the source selection decision);
 Proposal submittal requirements for the offerors to respond to the criteria;
 Procedures to be used to select a technical/management review team;
 Procedures for the technical/management review team to use in evaluating
technical/management proposals;
 Procedures for the purchasing professional to use in evaluating price/cost/business proposals;
 Plans for contract negotiation, if appropriate; and
 The designation of the source selection official (if other than the purchasing professional)

Evaluation Factors Included in the Solicitation
Purchasing professionals should assure (through use of a team approach) the solicitation language
contains the evaluation factors for award and proposal submittal requirements that are spelled out
in the source selection plan. In accomplishing this, the team should assure that all the items
identified below are accomplished.
SOLICITATION EVALUATION FACTOR AND PROPOSAL PREPARATION

INSTRUCTIONS
 The sections of the solicitation containing the factors for award and proposal submittal
requirements should be kept separate but are highly correlated and not inconsistent with each
other. (Each criteria must have a corresponding proposal submittal requirement addressing that
criteria);
 The evaluation criteria should be either listed in a descending order of importance or are
weighted, (with the total adding up to 100%);
 The proposal submittal instructions should contain proposal page limitations;
 The proposal submittal instructions should clearly specify the number of proposal copies to be
submitted;
 The proposal submittal instructions should clearly specify that price/cost/business proposal
level of detail should be limited to the highest practicable level of the work breakdown structure;
and
 The proposal submittal instructions should require the technical, management, and
price/cost/business proposal volumes to be separate, distinct documents.
Evaluation of Offers
Assuming the potential suppliers all respond timely and in conformance with the terms of the
solicitation, the purchasing team must then begin the evaluation process. The evaluation process
works best when predetermined forms and procedures govern the process. These predetermined
procedures generally call for the purchasing professional to log in all proposals and then
distribute the various sections to the evaluation team. The purchasing professional normally
retains all price/cost/business proposals. The purchasing professional generally retains one
"master copy" of all other proposals and then releases the remaining copies of the
technical/management proposals to the head of the technical/management evaluation team.
After the head of this team distributes the proposals, the members of the team conduct their
evaluation. Normally the team follows the following procedures:
(1) All members of the team review all proposals.

(2) Members of the team use pre-prepared evaluation forms. Rating schemes commonly used
include application of points to supplier responses to evaluation factors; use of color coding (blue
(exceptional), green (acceptable), yellow (marginal), and red (unacceptable) are the most
commonly used) to reflect categorization of quality of response to evaluation criteria; or use of
adjectival ratings, structured around a three, four, six, or ten descriptor scoring system.

A workable ten descriptor scoring system is shown below.
BEST VALUE/BUY PROPOSAL SCORING SYSTEM
ADJECTIVAL RATING SCORE
Outstanding 10
Superior 9
Excellent 8
Very Good 7
Good 6
Adequate 5
Weak 4
Poor 3
Very Poor 2
Inadequate 1
Nonresponsive 0
After aggregation of individual team member scores/ratings, the technical/management

evaluation team chief must identify each proposal as being within one of the following categories:
(1) Proposal is acceptable as received.

(2) Proposal might be brought to an acceptable status with a reasonable effort on the part of
the purchasing organization and the supplier.
(3) Proposal is not acceptable--no further consideration warranted. Proposals in this
category are so technically inadequate as to remove them from further consideration.
Examples of such deficiencies are the offer of an approach previously found unworkable
or the offer of an effort which is inconsistent with the stated objectives of the solicitation.
Documentation of Technical Evaluation
The team chief must document his/her findings in a memorandum to the purchasing professional.
If the purchasing professional plans to hold negotiations with the offerors, these negotiations
cannot commence until this report is received. In addition to communicating which of the three
above categories the proposals are in (and the results of the point evaluation, if conducted), the
technical/management team chief should include a narrative evaluation specifying the strengths
and weaknesses of each proposal and any reservations or qualifications that might bear upon the
selection of potential suppliers for inclusion within the competitive range. Specific technical
reasons supporting an unacceptable determination of any proposal should also be included.
Evaluation of Price/Cost/Business Proposal
Although the purchasing professional is primarily responsible for the price/cost/business proposal
evaluation and the pointing of these proposals, (if pointing is required by the evaluation plan in
the source selection plan), the purchasing professional who has requested and received detailed
cost proposals in the conduct of a best value source selection will have some additional effort on
his/her hands. In such circumstances (not the normal rule, since most procurements will not

require cost proposal submission because of the presence of price competition) the purchasing
professional will generally find it necessary to obtain technical evaluation input concerning the
cost proposals. The technical/management review team can assist in determining whether the
cost proposals reflect an adequate understanding of the work. Evaluation of the direct cost
elements can reveal whether the proposer has adequately provided for the required services,
materials, equipment, travel, and other expenses.
The cost proposal must provide a "mirror image" of the technical approach included in the
technical proposal. Failure of the offeror to address areas of work in the cost proposal should
cause the purchasing professional to question whether the offeror really understands the work.
This evaluation should address the items shown below.
FOCUS OF THE TECHNICAL EVALUATION
 The completeness of the supplier's proposed costs. This assumes the supplier presented
a work plan to accomplish the proposed efforts in its technical proposal. The degree to which
the supplier correlates and allocates the labor, material, and other resources to the work plan in
the technical proposal will directly influence the efficiency, productivity, and schedule
compliance.
 The relationship of the proposed costs to the required work. In this assessment, the
technical/management team will determine whether all costs proposed are necessary for the
satisfactory completion of the work. Proposed costs for work determined to be unnecessary
should be excluded.
 The degree to which the proposed effort is duplicated. A given cost proposal may
contain costs which have been proposed elsewhere in the same proposal or in prior proposals for
work that was completed prior to the instant contract.
 The validity of the estimating techniques employed in the proposal. If historical data is
used in projecting future cost, the team should determine if the current contract schedule,
workload, and other conditions have been adequately considered as a basis for projecting the
historical costs to the future.
 The impact of schedule and workload. This evaluation looks at the time period for the
contract scope of work and attempts to determine whether the total quantity of effort proposed is
correlated with that scope. The team will review the cost proposal to assure themselves there is
a proper balance of manpower working on a task versus the time span over which the task is
performed
Technical (Quantitative) Analysis of the Supplier’s Cost Proposal
In addition, if cost and price negotiations are required, the purchasing professional will need the
technical/management review team to provide a quantitative analysis of the offeror's quantities of
labor, materials, and equipment so that purchasing professional (or auditor) developed rates can
be applied against them in deriving a total cost position for negotiation. This analysis of the
supplier's cost proposal should address all the items identified below.
FOCUS OF THE TECHNICAL ANALYSIS OF THE SUPPLIER’S COST PROPOSAL

 The appropriateness of the proposed skill level and mix. This analysis is important because
labor is generally the largest element of cost in many contracts. Part of understanding and
evaluating estimated labor is to recognize the patterns in the incidence of different types of labor.
Each phase of a work effort will have its own unique combination of required labor types. The
skill, grade, and salary levels proposed must make sense when the phases are compared not only
with the job as a whole, but with each other.
 The reasonableness of proposed direct labor hours. This analysis attempts to determine
whether or not the supplier has based the hours on proper planning and that it contemplates the
sound use of labor and reasonable economy and efficiency of operation. The tests for labor hour
reasonableness will include consideration of the necessity of the proposed effort, the adequacy of
the work plan, whether any work has been duplicated, the applicability of historical data, the
conditions under which the work will be performed, the estimating methods employed, and the
supplier's knowledge of the task. (If the supplier has performed similar work for the purchasing
professional's organization or similar organizations, the supplier's personnel may manifest a
classical "learning curve", meaning their productivity will be greater than average on your
contract because they learned how to do the job on earlier contracts. Learning is a universal
phenomenon which applies to service contracts as well as supply contracts.)
 The reasonableness of the proposed material types and quantities. Material can be quite
significant as a cost element. Ideally, the supplier will have developed consolidated lists or bills
of materials based upon some sort of takeoff from existing plans and drawings. In that
eventuality, the engineer/technical member can readily compare the quantity of proposed material
with the quantity of material estimated on the detailed in-house estimate. In the absence of such
plans, the supplier may have to rely on historical experience. The supplier's estimate of material
quantities should be analyzed by not only comparing against prior contract usage but also by
projecting reasonable learning in the usage of materials. The learning curve applies in general to
use of materials as well as labor.
 The reasonableness of the proposed other direct costs (quantities). Other direct costs are
those costs which are specifically identified with a project but which do not fall within the
classification of direct labor or direct material. Examples include equipment, subcontracts,
travel, automatic data processing, consultants, and meetings and conferences. These direct costs
are reviewed to determine whether the costs are properly classified in accordance with the
supplier's accounting system, and the backup data in support of the costs are valid, current, and
applicable to the work required.
 The reasonableness of the proposed profit or fee. Although the technical team should
not be asked to develop a recommended profit or fee, it can render an opinion on the inherent
technical, management, and cost risk they perceive in the work as well as an opinion on the
degree to which the supplier is willing to assume that risk. Generally, higher cost estimates
(padding of cost, either in quantity or rates) evidence an unwillingness by the supplier to assume
risk.

Accounting/Rate Analysis
As we indicated earlier, the purchasing professional will need to develop rates (labor, material,
equipment, overhead, G&A, and profit) that can be applied against the quantitative positions
taken by the technical/management evaluation team in deriving a total cost position for
negotiation. This analysis of the supplier's cost proposal is called "Accounting or Rate
Analysis". In many organizations, the purchasing professional is assisted in this analysis by a
―cost/price analyst‖, an ―estimator‖, or even a ―contract auditor‖. Accounting Analysis should
determine the reasonableness of all the rates identified below.
RATES TO BE ANALYZED
 Proposed labor rates. On contracts with incumbent firms, it is a fairly simple proposition to
review historical payrolls and track specific employees to the proposal. Historical rates will, of
course, be extrapolated to reflect salary increases in effect during the period of performance.
These increases must, of course, be reviewed in the light of past history and economic
reasonableness before they are accepted. On contracts which require the supplier to acquire new
employees, the offer letters may be reviewed to determine rates. Lacking this evidence, wage
and salary survey information available from the American Management Association, the U.S.
Department of Labor, and others can be consulted for reasonable, market-based rates in the area
of contract performance.
 Proposed material prices. On contracts with incumbent firms, it is relatively easy to review
books and records to track prices paid for proposed materials. These prices paid, if used as a
basis for the estimate, would need to be extrapolated to the period of contract performance using
an appropriate whole price index escalator. On contracts with no previous incumbent
experience, proposed material prices should be pegged to whatever published, catalog, or market
prices are available in the literature. In conducting the material price analysis, the purchasing
professional or auditor/analyst/estimator acting in his/her stead must assure that costs are
consistently treated in accordance with the normal cost-keeping system of the supplier, that costs
are traceable to and can be supported by such documentation as bills of material, supplier quotes,
and subcontracts, and that costs are reasonable in view of actual prices, adjusted for trade
discounts, refunds, rebates, allowances, prompt payment, etc.
 Proposed other direct cost prices/rates. Other direct costs generally include a combination of
different types of costs, including specialized labor, equipment, and support-type costs. The
rates for these types of costs should be analyzed by pegging them wherever possible to the market
as well as past history and experience by the supplier and/or purchasing organization.
 Proposed overhead and General and Administrative (G&A) rates. If the supplier is doing
business with a governmental entity, the chances are that he will have been subjected to some sort
of overhead rate audit by that government entity. Audit results are formalized into a rate
agreement that tells the firm what rates will be used for prospective bidding purposes as well as
for retrospective (close-out) purposes. The purchasing professional should ask the supplier for a
copy of his latest governmental rate agreement. Failing that, the purchasing professional should
request the supplier divulge his detailed estimate of the costs included in the overhead and G&A
pool projections for the contract period in question, divulge his estimated bases used in
calculating his rates for that period, and explain how the rates were derived. Failing that, the

purchasing professional should request certified financial information from the company which
can be used to derive rate approximations.

Proposed Profit or Fee Rate
In addition to analyzing elements of cost the purchasing professional should assess the technical,
management, and cost risk of the work as well as determine the degree to which the supplier is
willing to assume that risk. Generally, higher cost estimates (padding of cost, either in quantity
or rates) evidence an unwillingness by the supplier to assume risk. In addition to considering
risk and the relative difficulty of the job, the purchasing professional should consider the size of
the job, the period of performance, the amount of investment being made by the supplier in
performing the work, the amount of assistance (purchasing professional-provided property and
financing) being provided by the purchasing organization, and the amount of subcontracting
involved.
Source Selection Decision
The source selection decision may be made without negotiation or further discussion, particularly
in those situations where two or more proposals have been rated as "acceptable" and price
competition is evident. In most procurements the purchasing professional will make the source
selection decision, giving full and due consideration to the technical/management team
recommendations. In more complex procurements, the source selection official may be a high
level manager in the organization, or even the general manager. If technical and/or price
negotiations are considered necessary, a systematic approach must be taken to the process of
negotiation.
Determination of Supplier Responsibility
Before an order can be placed with a supplier, the purchasing professional must make a
determination that the otherwise successful offeror is "responsible". This means, generally
speaking, that the purchasing professional must be sure that the supplier has the capability (called
competence, capacity and credit) and the willingness (called tenacity and perseverance) to do the
job correctly. General standards of responsibility (FAR, 1996), include the items included
below.
RESPONSIBILITY FACTORS
* Adequate financial resources to do the job, or the ability to obtain them;

* Ability to comply with the required or proposed delivery date or schedule, taking into account
all existing business commitments;
* Satisfactory record of performance (a supplier may generally be determined nonresponsible
based on recent unsatisfactory performance in the same or a related area of work);
* Satisfactory record of integrity and business ethics;
* The organization, experience, accounting and operational controls, and technical skills, or the
ability to obtain them (including, as appropriate, such elements as production control procedure,
property control systems, and quality assurance measures applicable to the materials to be
produced or services to be performed by the prospective contractor and subcontractors);
* The production, construction, and technical equipment and facilities, or have the ability to
obtain them; and

* Must be otherwise qualified and eligible to receive an award under applicable laws and
regulations.
In many cases, the purchasing professional, accompanied by appropriate technical team members,
will be required to visit the supplier's facility in order to gather the facts and information needed
to make an affirmative decision relating to supplier responsibility. If a team is assembled,
different individuals will be requested to address the supplier's ability to perform; the supplier's
financial status or condition; the supplier's quality control, quality assurance, and related systems;
the supplier's organization and management; and the supplier's labor status.
The purchasing professional's signature on the purchase order or contract is an affirmative

determination that the supplier is responsible.
Analyzing Supplier Performance Using Rating Systems
Most organizations will have individual supplier historical performance records and data on file
to assist them in their responsibility determinations. These ratings will generally address the
supplier's performance in terms of price, delivery performance, quality, and service. Some
organizations go beyond a simple rating system in more sophisticated systems, commonly known
as the "Categorical Method", the "Weighted-point Method", and the "Cost-Ratio Method".
These methods are explained below.
Categorical Method
This uses a strictly qualitative approach. In addition to keeping and maintaining a record of all
suppliers and their products or services, the purchasing department establishes a list of factors for
evaluation purposes. He assigns a grade to a particular purchase transaction which measures
supplier performance in each of the established areas. A grade of plus, minus, and neutral is
commonly used. Based upon some form of composite rating, the supplier is given an overall
rating and generally notified of the rating.
Weighted-Point Method
This method goes beyond the Categorical Method and assigns an appropriate weight to each
performance factor. The weight assigned is a reflection of the purchasing professional's
judgment about the relative importance of the specific performance factor. The purchasing
professional develops an overall rating for each supplier by multiplying each factor weight by the
performance number which corresponds to that factor and then adds the resulting mathematical
products. (This is similar to the "weighted guidelines" system used in Federal procurement).
The total of the resulting mathematical products determines the supplier's final rating for the
period. Some organizations use this method in conjunction with the categorical method.
Cost-Ratio Method
This method relates acquisition and handling/inventory costs to the value of each shipment
received from individual suppliers. The lower the ratio of costs to shipments, the higher the
rating for the supplier, and vice versa. Generally, the method is applied by first determining the

costs for quality, delivery, and service for each supplier; converting each of these three costs to a
cost ratio by dividing each cost by a given total order cost for a transaction; totaling the resulting
cost ratios to derive the supplier's overall cost ratio; and then applying the overall cost ratio to the
supplier's order price to develop an "adjusted price" which is equal to the actual price times 1 plus
the supplier's overall cost ratio. The organization would then use the adjusted price as the basis
for evaluating supplier performance.
Economics
A knowledge of the fundamentals of economics is essential for good purchasing. A particularly

important area is price theory.
Decisions to buy are rational with sufficient time, information, and resources. When knowledge is
used to apply energy to materials so that materials become more valuable it is called production.
Productive resources are land, labor, capital, and entrepreneurship. Adam Smith, an eighteenth
century philosopher sometimes called the father of modern economics, said that people act
rationally and with purpose to maximize their satisfaction, given their limited time, information,
resources, and budgets.
A purchase eliminates funds for investment in an alternative product. Opportunity cost is the
value of the best alternative given up when a choice is made.
There are two types of economics.
1. Normative economics is based on value judgments and is concerned with what should be.
2. Positive economics is based on what is and describes tendencies in economic behavior that
can be observed and tested.
The law of diminishing returns.
Less and less extra output is obtained when additional input is added when all other inputs are
fixed. This can be restated by saying that the marginal product from each unit of input will
decline as the amount of that input increases, holding all other inputs constant. For example,
suppose three requests for bids are sent out at a total administrative cost of $150 or $50 per
request and the difference in the lowest price from one supplier and the highest price from
another is $600. The saving from this action results in a net saving of $450. Therefore to improve
savings, six requests for bids are sent out for an administrative cost of $300, still $50 per re-quest.
The difference in prices between the lowest and the highest bidder now becomes $600. However,
the net saving is only $300.
How supply and demand affect price.
In general as supply increases price declines, as supply decreases price rises. Conversely, as price
is increased demand usually declines and as price is reduced, demand usually rises.

Types of Competition in the Market
Type Buyers Sellers

Market (Full and Open) Many Many
Monopoly Many One
Oligopoly Many Few
Oligopsony Few Many
Monopsony One Many
There are both legal and illegal monopolies. Holders of patents have a legal monopoly. In practice
there are few complete monopolies. A buyer usually has a choice of substitute products.
Types and use of price indexes.
Price indexes are numbers developed to measure changes in price levels of product categories.
The numbers are created from a weighted average of the prices of a number of items. Changes are
published and compared with previous periods. Data for the indexes are gathered by the
government and used to calculate various indexes. The most widely known index is the
Consumer Price Index or CPI. It measures the prices of products and services purchased by the
public. Buyers and sellers usually find the Producer Price Indexes or PPI more meaningful. The
PPI indexes measure the prices of various categories of goods purchased by business. Typical
indexes are for finished goods, capital equipment, containers, and materials and components for
construction.
The meaning of price elasticity.
The price elasticity of demand measures how much the quantity demanded of a product changes
when its price changes. When demand is price-inelastic, a price decrease reduces total revenue.
When price is price-elastic, a price decrease increases total revenue. When there is unit-elastic
demand a price decrease leads to no change in total revenue. The price elasticity of supply
measures the percentage change in quantity supplied divided by the percentage change in price.
The meaning of inflation and deflation and how buyers respond.
Price inflation is when there is a general increase in the level of prices. Deflation is when there is
a general decrease in the level of prices. Inflation is helpful to borrowers because they pay back
cheaper money than they borrowed. However, the lending rate usually anticipates the rate of
inflation and compensates for the reduction in the value of repaid debt. Inflation is harmful to
people on fixed incomes be-cause the fixed amount of money they have becomes less valuable
and earns less real dollars. Business buyers find it more difficult to make long term contracts at
fixed prices during periods of high inflation. This problem is circumvented by allowing what is
called "escalation." Inserting an escalation clause into the agreement allows the seller to increase
prices by an amount equivalent to the rate of inflation. Alternatively, buyers permit sellers to
increase prices to cover actual cost increases incurred by the supplier. Buyers often require the
seller to document these actual cost increases caused by changes in material and labor prices.
Agreements with suppliers should also include a provision requiring price reductions in the event
that deflation occurs.

International Trade
There are many similarities as well as many differences in making purchases internationally.
Today, every professional buyer should consider foreign suppliers if the amount of the purchase
justifies the additional administrative cost and risk involved. Also, there are many products that
can only be obtained by importing them.
The differences between international and domestic trade.
The major differences between domestic and international trade are language, culture,
transportation time or cost, and the duties imposed. In addition, there are added risks associated
with political instability. Language is not the barrier it once was because English is the accepted
language of business in most countries throughout the world. However, knowing the local
language does improve the ability to negotiate successfully. Perhaps more important than
language is knowledge of cultural differences and the customs of the country. For example, it is
the practice for the buyer to take gifts when visiting a supplier in Japan.
Finding international sources of supply.
The U.S. Government provides data that reveals what products are currently being imported from
each country so the buyer can look in those countries that supply needed products. Supplier
directories are published for foreign countries that give the names and addresses of companies
and what they sell. Buyers often receive help from foreign consulates in the U.S. who provide
lists of companies wishing to export to the U.S. Trading companies located in the foreign country
and with offices sometimes in the U.S. are a source of supply. They find manufacturers in the
foreign country and handle all the paperwork involved with the transaction as well as all of the
communications with the manufacturer. The disadvantage is that the trading company is a
middleman that involves an additional cost. Many buyers feel the cost is more than worth it. In
addition those manufacturers dealing with the trading company are often very small, difficult to
locate, and may not be able to or want to deal directly with the U.S. supplier.
Foreign exchange.
One complication involved in international trade is the differences in money used in the foreign
country and in the U.S. The amount of foreign currency equivalent to the U.S. currency constantly
changes and therefore it is necessary and important to establish pricing based on one currency or
the other and to establish the rate of exchange or how it will be set. Exchange rates are published
in the Wall Street Journal and available from major commercial banks.
Duties and other cost considerations.
The amount and responsibility for costs are subject to negotiations with the supplier, but the
following costs are incurred by someone.
Freight forwarders and customhouse brokerage fees

Processing shipping bills and tracking shipments may be handled by firms specializing in those
functions.
Custom duties
Import tariffs are imposed on products by the government. The amount of these duties varies
depending on the product or product category. Sometimes the duties are so high that importation
is unprofitable.
Freight to the dock in the foreign country
The cost of transportation to the port of departure is often paid for by the supplier depending on
negotiations, but the cost is eventually passed on to the buyer.
Ocean freight or air transportation cost
Ocean shipping is the usual method of transportation outside of North America for most products
that are bulky, heavy, or in large quantities. Expensive air transportation is normally used for
small quantities of critically needed items and for small and light weight products.
Freight from the port of entry to the final delivery point
Inland freight is a cost for either a domestic or an international shipment. It should not be
forgotten when comparing the total costs from a domestic supplier with an international supplier.
Insurance
Many companies have insurance that covers domestic shipments but does not include goods in
transit outside of the U.S. Buyers usually ignore the need for insurance for domestic shipments
either because the shipments are F.O.B. delivered, or because the value and risk of loss is small.
However, foreign shipments carry more risk and it is more difficult and takes longer to get paid
for any losses from foreign suppliers. It is wise to purchase insurance for international shipments.
Bank charges
There is a cost to exchange currency and pay for letters of credit. These charges vary from bank to
bank and may be small, especially for good customers, but whatever the amount, it should be
added to the total cost of the purchase.
Inspection charges
Independent inspection companies can be hired to check goods before shipment. This is an
economical approach if specifications can be verified from drawings or other documentation. The
inspector takes measurements or counts as required and reports the results. Goods can then be
approved for shipment or rejected before the cost of transportation is incurred. Companies that do
a high volume of international business or have many shipments may use an employee who lives

in or near the foreign country. Occasionally quality assurance personnel or buyers may travel to
make inspection of specific or random shipments.

Related travel expenses
It is not always necessary for a buyer to travel to a foreign supplier to conduct business. Many
foreign suppliers have offices or representatives, or even warehouses within the U.S.
Nevertheless, any anticipated travel expense deemed necessary by buyers or inspectors should be
added to the cost of the purchase.
Method of payment and letters of credit.
The usual method of payment for foreign purchases is by a letter of credit. An application for a
letter of credit is made by the buyer or the buyer's accounting department and issued by a
domestic bank and sent to a correspondent bank in the foreign country. The letter of credit
describes the goods and specifies what paper-work such as bills of lading and inspection reports
be prepared and accepted prior to shipment. An irrevocable letter of credit insures that payment
will be made by the foreign bank to the supplier upon shipment to the port or other destination if
the goods are prepared as specified and the paperwork is in order.
Law
Some believe that the single most important subject that buyers should know is the law. Without
such knowledge a buyer can cost the organization thousands, if not millions of dollars and even
run the risk of being put in prison. The law practices in the United States are based on English
common law in every state except Louisiana where it is based on the French tradition. Purchasers
who purchase globally (offshore) must be familiar with the CISG (Convention on International
Sale of Goods), which has been adopted by most developed countries of the world.
Types of law
Common law is based on established cases decided in court and ruled on by a judge. Future
decisions are based on previous rulings. Those previous rulings carry more weight when they
have been made closer to the jurisdiction considering the new case. For example, a New Jersey
court would pay more attention to a previous ruling made in New Jersey than it would to one
made in another state or country. Likewise, the court is likely to pay more attention to recent
rulings rather than older decisions. Most law is established from decisions made in previous cases.
Statute law is established from written documents approved by federal, state, county, or city
legislatures.
Laws that affect purchasing operations.
The law of agency establishes the rights and responsibilities of agents such as purchasing agents
and sales agents. Contract law establishes the requirements for a contract. The antitrust-trust laws
prohibit monopolistic practices and unfair dealings by buyers and sellers. Laws regarding
employment practices and environ-mental issues also affect purchasing operations. The Uniform
Commercial Code is the most important law for day to day purchasing operations. It is also
important for buyers to know the implications of patent and trademark law. International laws
vary from country to country and may affect how purchasing transacts business in those countries.

Defining a purchasing agent and other agents.
An agent is given authority by the principal. In the case of a buyer, the organization is the
principal represented by the person who hires the buyer or the person who the buyer reports to. In
the case of a salesperson, it is the organization that hires that salesperson. Authority may be
limited or complete. Purchasing agents usually have the authority to buy many different types of
products. They normally have the authority to select the supplier, negotiate, and make an
agreement (con-tract). Only authorized agents have the authority to make purchase agreements
and only authorized salespeople have the authority to make sales agreements. However, that
authority may be conveyed to individuals if they make those agreements on their own and are
allowed to continue to do so.
The responsibility of the agent is to be loyal to his or her employer and to protect the interests of
the employer. At the same time the responsibility of the employer (principal) is to pay the agent
and to honor the agreements made by the agent.
What makes a contract?
A contract is an agreement between individuals or organizations. There must be an offer,

acceptance, and mutuality of intent. There must be consideration (under the Uniform Commercial
Code, or UCC), the agreement must be concerned with legal subject matter, and the parties
contracting must be ―competent‖.
The contract need not be in writing unless it falls under the Uniform Commercial Code that
requires any transaction between merchants for an amount of $5,000 or more for goods (new
UCC) to be in writing in order to be enforceable. Buyers for business are considered merchants.
Goods are any tangible products, like production materials, components, and equipment.
Capable parties are those who are not insane, intoxicated, or under the influence of drugs.
Consideration is something of value such as money, goods, or services that are provided. There is
no requirement for consideration under the CISG.
There is a contract whenever a buyer makes a purchase.
What makes an offer and acceptance?
An offer may be made in the form of a bid or by actual shipments of goods, or by a written
document such as a letter or purchase order. An acceptance may be made by unprotected receipt
of goods or services, by use of goods, by a written document such as a letter or purchase order.
When you can and cannot cancel an order without penalty.
Generally, you can cancel an order without penalty if the products are stock items that can be sold
elsewhere and the supplier has not incurred any costs. You may be able to cancel if the supplier
fails to live up to the terms of the contract, particularly if you have given the supplier a chance to
correct errors and he has failed to do so within a reasonable time.

Remedy and right to recover damage and "cover."
If the seller fails to deliver goods according to the agreement, the buyer has the right to recover
damages. The buyer has the right to cancel the order and purchase the goods elsewhere and
recover any difference in cost from the failing supplier.
The importance of the UCC.
The Uniform Commercial Code or UCC is a law passed by all states except Louisiana that covers
transactions between merchants (buyer for business and seller) for goods (tangible products). The
law was passed to provide uniformity of interpretation of business agreements between firms
located in different states. It provides the terms and conditions of sale. It is the ruling document
for most agreements made by professional purchasing people unless such agreements specifically
make terms and conditions other than specified by the UCC. The law was recently updated and is
yet to be codified by most State Legislatures.
Types of warranties.
There are express warranties and implied warranties. Express warranties are established in
various ways. Samples that represent the product that will be purchased establish an express
warranty. Express warranties are given when a seller states what a product will do or gives a
specific description of a product such as its dimensions, chemical components, or type of material
making up the product. General statements in a sales brochure or by a salesperson such as "it is
the best product of its type" or that "it is better than the competition" are not express warranties.
They are called "puffery" and salespeople are expected to exaggerate the worth of their own
products for sale.
Under the UCC there is an Implied warranty of fitness for its intended purpose and Implied
warranty of merchantability when a product is sold by an organization that normally deals in that
type of product. If the buyer purchases using a buying organization specification, suppliers will
usually disavow these implied warranties.
Consequential damages.
Most warranties by suppliers cover the value of the product and not other costs that may result
from the product failure. A supplier's standard agreement form usually excludes the supplier from
liability for consequential damages. For example, if someone is injured as a result of product
failure, the costs of medical expenses or settling a law suit can be hundreds or thousands of times
more than the cost of the product. These are consequential damages.
Antitrust laws.
The penalties for breaking the antitrust laws can be imposed on either buyer or seller or both and
may be fines or imprisonment. The laws make it illegal to fix prices among suppliers, to
monopolize, and to conspire in restraint of trade. Reciprocity is a violation of antitrust wherein a
buyer agrees to buy from a company if that company also buys from the buying company. It is a

violation for competitors to agree to split territories. It is a violation to use tie in agreements
wherein a buyer must buy certain products in order to get other products.
Patents and trademarks.
Patents are basically monopolies to prevent others from making, using, or selling a product that is
authorized by the government. Trademarks are restrictions by the government for use of product
names, logos, and artwork by anyone other than the authorized trademark holder. Use by other
than the authorized holder of a patent or trademark can result in confiscation of products made or
purchased as well as payment to the authorized holder for any lost profit. Buyers should be aware
that imported goods that violate patents may be confiscated by customs even though the buyer has
already paid for them by a letter of credit or other means. The seller in the foreign country may
incur no loss since the U.S. law does not apply to them. However, companies may also obtain
foreign country patents.
Work for hire.
The design of products fully designed or in part designed by a supplier may be owned by the
supplier. If the buyer wishes to order the same item from another supplier, he may not be able to
do so unless the design is changed. To avoid this problem, the contract for the products or
services should include a term that the order is "work for hire." This means that any creative
effort is being done for the buyer and becomes the buyer's property to use in any way desired
without further cost.
Terms and Conditions.
The buyer may specify many different terms and conditions and negotiate with the supplier to add
or delete various terms. As a minimum, nearly all purchase orders should include the F.O.B. point,
the payment term, the place for delivery, the date for delivery, the quantity, and a price term.

Payment Terms
There are dozens of possible payment terms. Here are the most common.
Net
The same as cash. Payment is due upon receipt of the goods.
Net 30 or Net 60 or Net 90, etc.

Payment is due within 30 days (or 60, or 90, or whatever number of days specified). Many buyers
further define all net terms to indicate that payment is due the specified number of days after
either the due date, the date of actual receipt of the goods, or the date of the invoice, whichever is
later.
1% 10, Net 30, or 2% 10, Net 30, etc.
A discount of 1% (or 2% or whatever other percentage specified) may be taken off of the invoice
if paid within 10 days (or any other number of days specified), but the full amount is due within
30 days (or any other number of days specified). This is a ―prompt payment discount‖. A typical
discount is 2%, 10, net 30. In order to determine the ―interest rate foregone‖ or ―annualized cost
of foregoing a prompt payment discount‖, you need to use the following formula:
2%, 10 Net 30
ab c
a/1-a X 360/c-b
For the above discount, the result is .01/.98 X 360/20 or 36.7%.
F.O.B. term and other terms indicating where title passes.
F.O.B. is one of the most important and misunderstood terms. It literally means "free on board"
and is where title (ownership) of the goods passes from the seller to the buyer. The following are
the most common uses.
F.O.B. Destination
Title to the goods passes from seller to buyer after it is delivered to the specified destination. The
supplier owns the goods up to that point and is therefore responsible for all costs unless otherwise
agreed and responsible for the goods.
F.O.B. Shipping Point or Origin
Title to the goods passes to the buyer immediately upon shipment at the shipping location
wherever that may be. The buyer becomes owner of the goods at the shipping point and is there-
fore responsible for all costs including transportation unless otherwise agreed and is also
responsible for payment of the goods.
F.O.B. Detroit (or any other city or location)

The same reasoning applies as in the above two examples.
In addition to the above Domestic Shipping Terms, the following ―Incoterms‖ (International
Chamber of Commerce Terms) are common. There are 11 ―Incoterms‖ contained in a pamphlet
available from the International Chamber of Commerce.
C.I.F. (plus a named location)
A term used for goods shipped by ocean and meaning Cost, Insurance, and Freight. The seller
pays all cost, insurance, and shipping charges to the named location where the buyer takes title to
the goods.
F.A.S. (plus a named port)
A term used for goods being sent by ocean and meaning Free Alongside Ship. The seller pays all
charges up to that point where title passes to the buyer.
International Law
With burgeoning global commerce, a new lexicon, if not alphabet, must become familiar to the
purchasing professional. This is the United Nations Sales Convention, or Convention on
International Sale of Goods (CISG), officially presented in Vienna in 1980 and since embraced by
countries from all parts of the world. The CISG has now become the uniform international
purchasing code of countries that account for over two-thirds of all world trade.
One stark example shows the importance of the CISG: A typical contract boilerplate may say that
"the law of New York State applies" to a transaction. The parties to an international sale of goods
may be shocked to find that this now can mean that the CISG governs their transaction -- for the
simple reason that treaties signed by the United States take precedence over state laws where they
apply.
Similar but Different

While the CISG is similar to the UCC in many respects, there are important differences that every
purchasing professional should know.
Like Article 2 of the UCC, the CISG applies to sales of goods, and governs the formation of the
contract and the rights and obligations of the seller and purchaser. It leaves to domestic law most
questions of validity as well as questions of the contract's effect on the property interest in the
goods sold. It does not apply to contracts to supply services, or to consumer sales or sale of
securities, ships, vessels, hovercraft, aircraft, or electricity, or to contracts for goods in which the
purchaser undertakes to provide a substantial part of the materials necessary to manufacture or
produce the goods. What remains, however, is a vast array of transactions in every imaginable
line of business. Sales of airplane engines and wine, candy and copper and nickel, textiles and
clothing, computers and test tubes and trucks are among the many situations that have appeared in
courts around the world and been held subject to the CISG.

The CISG applies automatically to contracts of sale of goods between parties whose places of
business are in different countries where those countries have adopted the CISG by signing the
Convention (so-called Contracting states). It may also apply to such contracts when one party, or
even neither party, is from a Contracting state. The parties can agree in their contract that the
CISG applies. Many reported cases involve contracting parties from countries that have not yet
signed the CISG -- evidence of its impact on businesses, whether or not their governments have
embraced its provisions.
The CISG works like the Book-of-the-Month Club. When subscribing, a member automatically
receives a book each month unless he takes the initiative and indicates otherwise. The CISG is
such a "club." When a country subscribes to the CISC it can automatically receive this "book" of
laws as the governing law of their applicable contracts, unless the parties indicate otherwise. This
is why, if your purchase order states: "This transaction shall be governed by the law of the state of
New York" and it's an international purchase covered by the CISG, the CISG "and not the UCC --
is what you are apt to get, even though you may have expected to get the UCC.
Freedom of Contract
The most fundamental provision of the CISG is freedom of contract. This means you can contract
out of the CISG if you want to. In order to do so, however, the contract should clearly and
explicitly state that you do not wish the CISG to apply. Within limits, you can also vary any of its
terms. By tradition, the typical U.S. purchase order is today tailored to the provisions of the UCC.
When the CISG applies, the boilerplate provisions of your purchase orders ought to be tailored to
it.
In its substantive provisions, the CISG has many similarities to the UCC; in that respect, much of
it requires minimal adjustment for U.S. parties. But, it also has features similar to civil law. They
follow.
Can an Oral Deal Be Binding?
Forget about Sam Goldwyn's maxim, "An oral contract is not worth the paper it is written on." As
a general rule, under the CISG there is no way you can prevent assertions that contracts have been
concluded solely on the basis of oral statements, for example, during the course of a telephone
conversation. Recommended steps to help avoid honest misunderstanding include documenting
your conversations -- a routine that is generally desirable in any negotiation. Also, conclude your
conversation with, "You, of course, recognize that we do not have a contract until..." This
approach can help avoid honest misunderstandings. Finish by sending a follow-up letter that sets
forth the precise status of the negotiations.
Offers May Be More Binding Than You Thought
Suppose you say, "If I do not receive your acceptance by April 22 this offer expires." Under the
UCC, you may generally withdraw this offer prior to April 22 if the other party has not yet
accepted it. Under the CISG, this may not be the case -- unless you say so.
It May Not Be as Easy to Cancel a Contract

It's generally easier to cancel a contract under the UCC than under the CISG. On the other hand, if
you want to improve your ability to cancel a contract that is governed by the CISG, you can easily
do so by putting the right words and phrases in your standard terms and conditions.
Notification of Defects
As a purchaser, pay special attention to notification of defects. Under the CISG, you lose all
remedies unless you send a timely notice of defects. The UCC also has such a rule. But there are
circumstances in which the CISG's notice requirements can be tighter. How do you respond to
this? Put in your terms and conditions the notice rules you think are most appropriate to the
product you are purchasing.
Other variations between the CISG and the UCC exist. Some of the other differences are of a
more technical nature. For purchasers that source internationally, understanding the differences
between the CISG and UCC can help in negotiations and final contract development.
If you contract with an international supplier and don't want to use the CISG, memorize article 6
of the CISG, "The parties may exclude the application of the Convention..." and include the
phrase in your contract. Then specify the use of the UCC in your contract.
International Negotiations and Oral Agreements
Sometimes, international parties in a negotiation may be motivated to take your discussions as

offers. Under the CISG, there is no provision for preventing assertions that contracts have been
concluded solely on the basis of oral statements. To avoid committing yourself follow the advice
below.
 Document your conversations.
 Conclude the conversation with, "You, of course, recognize that we do not have a
contract until..."
 Send a follow-up letter that sets forth the precise status of the negotiations.
Find out about the CISG on the Internet at WWW.CISG.LAW.PACE.EDU.
Countries that account for two-thirds of all world trade have adopted the CISG as their governing
uniform international sales law. Even if you've set terms and conditions that exclude the CISG, in
a battle-of-the-forms transactions, it may govern your purchase if your supplier's acceptance
doesn't exclude the CISG. So, the CISG continues to require the careful attention of today's
international purchasers.
Anti-Boycotts Legislation
These pieces of legislation pertain to organizations doing business which might "cooperate" in the
boycott of one nation against another. It is erroneously presumed to apply only to transactions
occurring in the Middle East (the Arab-Israeli boycott). However, it also applies to "boycotts" in
such other areas as India versus Pakistan and the Peoples‘ Republic of China (mainland) versus

Republic of China (Taiwan). The issues are often subtle, and frequently occur in such innocuous-
looking documents as letters of credit. There is a requirement to "report" requests to participate in
a boycott, which is very frequently overlooked, and results in the majority of violations by and
prosecutions of purchasers and sellers.

Foreign Corrupt Practices Act
While this impacts the seller more frequently than the purchaser, it should not be overlooked.
Essentially, it prohibits an organization or individual from making a payment that might benefit a
foreign official. Purchasers should review it with legal counsel, so that they can recognize the
issues which trigger its provisions.
Customs Laws
This is the body of law which governs the importation of goods into the United States. These
laws will impact virtually all imported goods (and some services). They are quite complex, and
will generally require the assistance of a customs broker or other import specialist.
Export Administration Act
Purchasers frequently overlook these laws, as they do not perceive themselves as "exporting." In
reality, whenever a specification, drawing, or prototype is provided to a foreign person or entity,
an "export" of technology occurs. While a majority of such exports are not restricted, some may
be, and such controlled exports are not always obvious. As is the case with importation, the key
here is to obtain advice and/or assistance from an "expert." This may often be someone other than
the expert who is used for importation.
Antitrust and Unfair Trade Practices

There are four principal federal laws which deal with antitrust and competitive practices:
1. Sherman Antitrust Act (1898)
2. Federal Trade Commission Act (1914)
3. Clayton Antitrust Act (1914)
4. Robinson-Patman Act (1936)
Each of these was intended to promote competition and to ensure that a fair and open marketplace
exists in the U.S. economy. Many states have similar legislation, but such laws would generally
apply only to transactions within that state. Most of the federal and state legislation is aimed at
trade practices of sellers, although some provisions apply either directly or indirectly to
purchasers. Volumes are written about each of these laws, however, the following discussion
emphasizes and highlights the provisions which are relevant to the purchasing professional.
Sherman Antitrust Act
This legislation prohibits any action or conspiracy "in constraint of trade," and prohibits any
"monopoly or attempt to monopolize." Most prosecutions under this act are for price fixing, bid
rigging, or other forms of collusion among sellers. However, it also prohibits reciprocal dealings
whereby a purchase of one product by a purchaser is conditioned upon the reciprocal purchase by
the seller of a product from the purchaser‘s organization. The purchasing professional should be
aware that such actions are prohibited by law, and should avoid any conduct which might be
perceived as encouraging or condoning such activities.
Federal Trade Commission Act (FTCA)
The FTCA created the Federal Trade Commission (FTC), and provided the power for the FTC to
interpret trade legislation such as the Sherman Act‘s "restraint of trade" provisions. It also

prohibited "unfair competition" and "unfair or deceptive" trade practices. These prohibitions are
clearly aimed at the seller‘s practices, and have very limited application to purchasers.
Clayton Antitrust Act
This legislation declared "price discrimination" to be illegal, and prohibited sellers from
exclusive-dealing types of arrangements with purchasers and/or product distributors. Some of its
provisions also govern corporate mergers or acquisitions that might create a monopoly. The
Robinson-Patman Act significantly amended many of the substantive provisions of the Clayton
Act, and is now the primary legislation to deal with these subjects.
Robinson-Patman Act
This legislation is the most familiar to purchasing professionals and is often used as an excuse by
sellers to not provide lower prices to purchasers during aggressive negotiations. This Act
specifically prohibits sellers from "price discrimination," where the effect of such discrimination
may substantially limit competition or create a monopoly. While this is obviously aimed at sellers,
there is also a provision which prohibits purchasers from "knowingly inducing" a discriminatory
price. It should be emphasized that the purchaser can be liable under these provisions only if the
seller was guilty of price discrimination that had the stated adverse effect on competition in the
marketplace. There are several defenses to liability contained in the Act, which make prosecution
difficult. It is for this reason that there have been no Robinson-Patman Act cases filed by the FTC
in the 1990s. Where does this leave the purchasing professional? According to James Johnstone,
in "The Robinson-Patman Act: No Barrier to Effective Purchasing," in Purchasing Today®,
September 1996, The Robinson-Patman Act does not present a real barrier to effective,
aggressive purchasing. The purchaser should not "knowingly induce" a discriminatory price;
however, most price concessions are not "discriminatory." A few older cases of purchaser liability
were based on a purchaser purposely misleading a seller to lower its prices based on a false
assertion that the seller‘s competition had provided a lower price. While a seller may legally
lower its price to "meet competition," the purchaser should not mislead a seller in negotiations.
These laws are complex, and this summary is intended to provide only general guidance on this
subject. The purchasing and supply professional should consult with legal counsel whenever
circumstances create a suspicion of prohibited conduct by the seller, or when purchasers‘ actions
could conceivably violate such laws.
Foreign Laws to Consider
The above mentioned are only a few of the U.S. laws which may apply to international
transactions. However, U.S. laws should not be a purchaser‘s only concern: these transactions
will also be affected by the laws and regulations of the other country or countries from which
goods or services are purchased. This is an area about which volumes are written, and is too
complex to cover in this publication. This is particularly significant considering that each country
will have its own unique laws and regulations which will apply only in certain circumstances.
This is, therefore, an area that will require consultation with an attorney who is familiar with the
local country‘s legal system. Relatively few U.S. attorneys possess such expertise, so be cautious
who you engage for such advice. This may require engaging a foreign attorney, but this is not
always the case. Some areas of foreign law which should be considered are:
Contract law. In some countries, certain contracts require approval of the local government. It
would be important to know if this is a requirement.

Export control. Just as the United States Government controls exportation of certain
commodities or services, foreign governments may prohibit or control export of the item(s) being
procured.
Currency control. Not all countries allow transactions to be conducted in U.S. dollars or other
non-local currencies. This may be a critical element to address in the terms and conditions.
Criminal law? Yes, your transaction could be "illegal" if structured in a certain manner. Criminal
liability in some countries is a considerably different concept than in the United States with all of
our due process protection of the individual. This is not something you want to find out the hard
way.
Terms and Conditions for International Purchases

As with establishing any contract, the purchasing and supply professional must: (1) understand
the environment in which he or she is operating, (2) recognize the risks associated with the
transaction in this environment, and (3) properly allocate these risks by clearly defining the rights
and obligations in the contractual terms and conditions.
There should be no doubt that the environment for international purchases is considerably more
complex. It follows that the terms and conditions for such transactions will be equally complex.
The complexity will naturally be influenced by the following factors:
 the country with which you are contracting
 the size of the transaction
 the type and technical complexity of the goods or services being purchased
 any previous relationship between the parties
 consideration of the issues unique to the international transaction which are outlined
above
Because of the multitude of transactionally unique issues to be addressed, there is no "standard"
set of terms and conditions which are appropriate for all international transactions. Most
organizations‘ "boilerplate" approach to purchase order terms and conditions will be especially
inappropriate for international transactions. This is an area that will require "customization" for
each transaction. The best approach to the task of drafting such terms and conditions is to utilize a
checklist to ensure that this multitude of issues is considered and addressed. Such checklists are
available to the purchasing professional from many sources, such as Business Laws, Inc. in their
Legal Aspects of International Sourcing. A list of "minimums" should also be developed to
replace or supplement the purchaser‘s domestic purchase order or contract. There are many
clauses which may be appropriate only for specific circumstances or transactions. Consequently,
even the seasoned professional should use a checklist to ensure that all issues are considered and
adequately addressed in the terms and conditions. In international sourcing, Incoterms are
normally invoked.

Incoterms 2010
ICC International Chamber of Commerce
WWW. WWW.iccbooks iccbooks..com com
These are the international commercial terms. They are a set of rules for the interpretation of
trade terms, in a contract of sale. They are published and regularly updated by the International
Chamber of Commerce to help parties to avoid misunderstandings, with all the waste of time and
money that this entails.
Purpose of the Incoterms

1. To determine the seller‘s and buyer‘s respective obligations concerning responsibilities and
charges for the transportation of goods from the seller‘s premises to the buyer‘s place.
2. To avoid any misunderstanding in the following questions : ―Who is responsible for what ?
Who is going to pay for what ?‖
An incoterm is a 3 letter word followed by a name of place. They apply only to the contract of
sale in some very distinct respects They deal with a number of identified obligations imposed
on the parties.
The eighth published set of pre-defined terms, Incoterms 2010 defines 11 rules, reducing the 13
used in Incoterms 2000 by introducing two new rules ("Delivered at Terminal", DAT; "Delivered
at Place", DAP) that replace four rules of the prior version ("Delivered at Frontier", DAF;
"Delivered Ex Ship", DES; "Delivered Ex Quay", DEQ; "Delivered Duty Unpaid", DDU). In
the prior version, the rules were divided into four categories, but the 11 pre-defined terms of
Incoterms 2010 are subdivided into two categories based only on method of delivery. The larger
group of seven rules applies regardless of the method of transport, with the smaller group of four
being applicable only to sales that solely involve transportation over water.
Rules for Any Mode(s) of Transport
The seven rules defined by Incoterms 2010 for any mode(s) of transportation are:
EXW – Ex Works (named place of delivery)
The seller makes the goods available at its premises. This term places the maximum obligation on
the buyer and minimum obligations on the seller. The Ex Works term is often used when making
an initial quotation for the sale of goods without any costs included. EXW means that a seller has
the goods ready for collection at his premises (works, factory, warehouse, plant) on the date
agreed upon. The buyer pays all transportation costs and also bears the risks for bringing the
goods to their final destination. The seller doesn't load the goods on collecting vehicles and
doesn't clear them for export. If the seller does load the good, he does so at buyer's risk and cost.
If parties wish seller to be responsible for the loading of the goods on departure and to bear the
risk and all costs of such loading, this must be made clear by adding explicit wording to this
effect in the contract of sale.
FCA – Free Carrier (named place of delivery)
The seller hands over the goods, cleared for export, into the disposal of the first carrier (named by
the buyer) at the named place. The seller pays for carriage to the named point of delivery, and risk
passes when the goods are handed over to the first carrier.

CPT - Carriage Paid To (named place of destination)
The seller pays for carriage. Risk transfers to buyer upon handing goods over to the first carrier.
CIP – Carriage and Insurance Paid to (named place of destination)
The containerized transport/multimodal equivalent of CIF. Seller pays for carriage and insurance
to the named destination point, but risk passes when the goods are handed over to the first carrier.
DAT – Delivered at Terminal (named terminal at port or place of destination)
Seller pays for carriage to the terminal, except for costs related to import clearance, and assumes
all risks up to the point that the goods are unloaded at the terminal.
DAP – Delivered at Place (named place of destination)
Seller pays for carriage to the named place, except for costs related to import clearance, and
assumes all risks prior to the point that the goods are ready for unloading by the buyer.
DDP – Delivered Duty Paid (named place of destination)
Seller is responsible for delivering the goods to the named place in the country of the buyer, and
pays all costs in bringing the goods to the destination including import duties and taxes. This term
places the maximum obligations on the seller and minimum obligations on the buyer.
Rules for Sea and Inland Waterway Transport
The four rules defined by Incoterms 2010 for international trade where transportation is entirely
conducted by water are:
FAS – Free Alongside Ship (named port of shipment)
The seller must place the goods alongside the ship at the named port. The seller must clear the
goods for export. Suitable only for maritime transport but NOT for multimodal sea transport in
containers (see Incoterms 2010, ICC publication 715). This term is typically used for heavy-lift or
bulk cargo.
FOB – Free on Board (named port of shipment)
The seller must load the goods on board the vessel nominated by the buyer. Cost and risk are
divided when the goods are actually on board of the vessel (this rule is new!). The seller must
clear the goods for export. The term is applicable for maritime and inland waterway transport
only but NOT for multimodal sea transport in containers (see Incoterms 2010, ICC publication
715). The buyer must instruct the seller the details of the vessel and the port where the goods are
to be loaded, and there is no reference to, or provision for, the use of a carrier or forwarder. This
term has been greatly misused over the last three decades ever since Incoterms 1980 explained
that FCA should be used for container shipments.
CFR – Cost and Freight (named port of destination)
Seller must pay the costs and freight to bring the goods to the port of destination. However, risk is
transferred to the buyer once the goods are loaded on the vessel (this rule is new!). Maritime
transport only and Insurance for the goods is NOT included. This term is formerly known as CNF
(C&F).
CIF – Cost, Insurance and Freight (named port of destination)
Exactly the same as CFR except that the seller must in addition procure and pay for the insurance.
Maritime transport only.

Duties of buyer and seller according to Incoterms 2010
SERVICES
EXW FCA FAS FOB CFR CIF CPT CIP DAT DAP DDP
Warehouse S S S S S S S S S S S
Storage
Warehouse S S S S S S S S S S S
Handling
Export S S S S S S S S S S S
Packing
Loading B S S S S S S S S S S
Charges
Inland B S* S S S S S S S S S
Freight
Terminal B B S S S S S S S S S
Charges
Forwarder’s B B B B S S S S S S S
Fees
Loading on B B B S S S S S S S S
vessel
Sea/Air B B B B S S S S S S S
Freight
Charges on B B B B B B S S S S S
arrival
Duty, Taxes B B B B B B B B B B S
& Customs
clearance
Delivery to B B B B B B B B B S S
destination
Previous terms eliminated from Incoterms 2000
DAF – Delivered At Frontier (named place of delivery)

This term can be used when the goods are transported by rail and road. The seller pays for
transportation to the named place of delivery at the frontier. The buyer arranges for customs
clearance and pays for transportation from the frontier to his factory. The passing of risk occurs at
the frontier.
DES – Delivered Ex Ship (named port of delivery)
Where goods are delivered ex ship, the passing of risk does not occur until the ship has arrived at
the named port of destination and the goods made available for unloading to the buyer. The seller
pays the same freight and insurance costs as he would under a CIF arrangement. Unlike CFR and

CIF terms, the seller has agreed to bear not just cost, but also Risk and Title up to the arrival of
the vessel at the named port. Costs for unloading the goods and any duties, taxes, etc… are for the
Buyer. A commonly used term in shipping bulk commodities, such as coal, grain, dry chemicals -
- - and where the seller either owns or has chartered, their own vessel.
DEQ – Delivered Ex Quay (named port of delivery)
This is similar to DES, but the passing of risk does not occur until the goods have been unloaded
at the port of destination.
DDU – Delivered Duty Unpaid (named place of destination)
This term means that the seller delivers the goods to the buyer to the named place of destination
in the contract of sale. The goods are not cleared for import or unloaded from any form of
transport at the place of destination. The buyer is responsible for the costs and risks for the
unloading, duty and any subsequent delivery beyond the place of destination. However, if the
buyer wishes the seller to bear cost and risks associated with the import clearance, duty,
unloading and subsequent delivery beyond the place of destination, then this all needs to be
explicitly agreed upon in the contract of sale.
Cultural differences.
A purchaser must consider cultural differences as well as legal-system differences. There are a
many cultural differences between countries, but there are three major differences that affect
purchase contracting.
The first difference is a different emphasis on "uncertainty avoidance," a term developed and
explained by Geert Hofstede in his pioneering book Culture's Consequences. Simply put, it
reflects differences in how sure people in a culture want to be of the future before they will
proceed with something. France and Japan have high uncertainty avoidance scores. The U.S. has
a fairly low score. This cultural characteristic affects lead time and flexibility more than it affects
anything else.
In addition to different emphases on uncertainty avoidance, there are different mechanisms for
coping with uncertainty. In the U.S., a legal contract is a major uncertainty avoidance mechanism.
A normal American reaction to any potential difficulty is "put it in the contract." We even usually
have a "complete agreement" clause, which states that the total understanding between the
companies is in the contract. A contract reduces uncertainty by allowing a powerful third party,
the courts, into a dispute.
In most Asian countries, even those with high uncertainty avoidance, contracts are much shorter
and much vaguer. In those societies, the major uncertainty avoidance mechanism is to get to
know potential business partners very well before entering into a business relationship.
This leads to the second major cultural difference, the importance of a personal relationship in
business. The US treats business rather impersonally compared to other countries. Fons
Trompenaars, a Dutch researcher, illustrates this well. He runs multinational workshops in
Europe where he asks for reactions to hypothetical situations. One question involves a car
accident where your close friend is driving. The friend is speeding and injures a pedestrian. The
friend's attorney comes to you and encourages you to lie in court to protect your friend.
Trompenaars asks two questions: What right does the friend have to ask you to lie in court?
Would you or would you not lie? Approximately 95% of Germans, Canadians and Americans
answer either that the friend had no right to ask this or the friend had some right but they still

wouldn't lie. Approximately 65% of Spanish and 25% of Koreans give these answers. While
Trompenaars' book seems to treat this data as an 'honesty graph', it's much more enlightening to
consider it as a graph of the different importance and sense of obligation given to friendships in
different countries.
Trompenaars specifically suggests not loading contracts with penalty clauses or strict
requirements when dealing with cultures that get low scores on this exercise. These clauses will
be seen as an accusation that the other party would cheat if the contract didn't forbid it, and a
person whose integrity is challenged may react by acting with less integrity.
The third major cultural difference is the attitude toward contracts. Western cultures, and
particularly the United States, tend to believe "a deal is a deal," and once a contract is signed
everyone is expected to follow it without requesting changes. As a result, contracts are expected
to cover everything that could happen and become very long. In most Asian countries there is a
more flexible attitude. A contract is seen as more of a guideline, and life with its frequent changes
is seen as too complex to capture all the possibilities in a written document. As a result, if
something unexpected happens, either party is able to reopen negotiations. Both parties are
assumed to be well intended and to take reasonable care of each other's interests.
Both of these attitudes toward contracts can be carried to counterproductive extremes. The best
solution is somewhere in the middle.
U.S. legal practices. There are a few legal practices that are especially disturbing to sellers in
other countries. We already mentioned one, which is that contracts become lengthy because too
many items go into them. A second one is that they are wordy and written in a special type of
English, legal English (More on correcting that later). A third common problem is that they are
written one-sidedly and give the buyer a variety of rights and the seller as few rights as possible.
Domestically, we recognize that the draft language is usually negotiable and the buyer often
doesn't seriously intend to insist on it. Buyers routinely, and sometimes carelessly, send these
draft documents to foreign sellers with an assumption that they will ask to have items changed if
they find them distasteful. Some special caution is needed here. There have been academic
studies that show that one of the biggest obstacles to a negotiated agreement that could have been
win-win is the opening offer being seen as completely unreasonable to the other party. A seller
faced with an unreasonable contract may draw back from the deal.
Purpose of contracts. I see two major purposes for written, signed agreements between the buyer
and seller. The first purpose is to get people to write down and agree (in some degree of detail) to
the major responsibilities of the parties. I believe this is especially important when dealing with
foreign suppliers. This exercise will bring most disagreements and misunderstandings into the
open before business starts. It also creates a document that will survive personnel changes.
The second major purpose is to use a signed, legally enforceable agreement to get a party to do
something they would not do otherwise. A strong third party, normally a court, enforces
compliance. Achieving this goal is much more difficult when dealing internationally. The
international legal system is slow and expensive. A legal cycle may be several times longer than a
product life cycle. Many major companies do not try very hard to make an agreement that will be
useful in court.

Preparing a contract draft. Here are six key steps to take in preparing a contract proposal for
foreign suppliers. This is by no means an exhaustive list, but one designed to reduce problems
due to legal and cultural differences.
1. Remove all clauses from your standard contract that are applicable in the US only.
Some of these are veterans' rights, EEO, and OSHA clauses. Even if a clause says "when
applicable" take it out if it isn't applicable. One very common clause states in essence
Seller will follow all U.S. federal, state and local laws." A foreign supplier will have a
difficult time even deciding which laws are applicable, if any. If there is a particular U.S.
law or group of laws that you want the seller to follow, state it.
2. Rewrite or eliminate all clauses that are too harsh or one-sided. Carefully consider
whether they are necessary, and if not, take them out. A clause stating that the supplier
will not sell to anyone else at a lower price, for example, is a poor way to start a new
relationship. If there is a clause that you would normally agree to make two-way during
negotiation, make it two-way before the supplier sees it.
3. Simplify the English. Legal writing is often indefensibly hard to read. If one of the
major purposes of an agreement is to document expectations, then the contract should
function as a communication tool. If you are working with an attorney, this is not a trivial
problem. Many complex contract clauses have been passed on from attorney to attorney
over the years with a comment that "this has worked in the past." To rewrite them into
simple English will take time and thought. You might face resistance.
Fortunately, you have support. The Securities and Exchange Commission has drafted
rules that require prospectuses to be written in plain English. Vice President Gore's
Reinventing Government program is requiring all government communications to be
written in plain English. Both organizations have published guidelines. Some key
recommendations are:
o use active verbs

o use short sentences
o avoid legalese and jargon
o use bulleted lists and tables, rather than long lists of words separated by commas
A good test, and an enlightening exercise, is to use your word processor's grammar
checker on your contract proposal. Often, the grammar checker will reject entire
paragraphs. (Think of the effect of this style of writing on someone for whom English is a
second language.) Pay attention to typography, white space and overall appearance of the
document.
4. Decide if you want to have the United Nations Convention on the International Sale of
Goods (CISG) applicable to your contract or not. The CISG is a UN treaty that the US and
several other countries have signed. If the buyer's and seller's countries have both signed it,

it will be applicable to your contract unless you specifically exclude it. There are some
aspects of the CISG that are unfavorable to buyers and some that are unfavorable to sellers,
and it is not completely understood. Most companies exclude it. You will need to put
specific exclusionary language in your agreement: "The United Nations Convention on the
International Sale of Goods will not apply."
5. Consider arbitration rather than courts to solve problems. Arbitration will be faster and
less costly in most cases. It also will tend to reach a compromise, rather than have one
party prevail completely. It is a good solution for solving what both parties see as a
temporary impasse in their relationship.
6. Establish the courts and legal system under which disputes will be settled. You need to
pick a country and city. If the supplier has all of its assets in its home country, often the
best choice is the supplier's home country. This works best if the buying company has a
legal presence in the supplier's country and there is a stable, functioning legal system.
Mathematics
The ability to do arithmetic is essential for any buyer or purchasing manager. A purchasing
professional should be skilled in taking percentages, converting decimals and fractions, and in
converting units of measure. Knowing the true time value of money helps determine actual
purchase cost.
Using decimals and fractions.
The fractions 1/2, 3/4, and 7/8 convert to and are equivalent to the decimals 0.5, 0.75, and 0.875.
These conversions are obtained by dividing the top number known as the numerator by the
bottom number known as the denominator. The decimals 0.125, 0.375, and 0.1875 convert to and
are equivalent to the fractions 1/ 8, 3/8, and 3/16.
Calculating percentages.
Fractions are converted to percentages by first converting them to decimals and then multiplying
by 100. For example 1/4 converts to 0.25 which becomes 25%. Multiplying by 100 only requires
moving the decimal point two places to the right. It is important to establish the proper base when
calculating the percentage change. For example, suppose a supplier was charging $10 for an item
and raises the price to $12. The base was 10. Dividing 2 by 10 converts to a 20% increase.
However, if the price was $12 and the buyer negotiates a reduction to $10, the savings is only
16.66%. It is a saving of $2, but 2 divided by the base of 12 converts to 0.1666 or 16.66%.
Converting units of measure.
It is important to use the correct unit of measure to multiply the quantity by the same unit of
measure as the price. For example, if the price is given per foot, then the quantity should be in

feet in order to compare total cost. If the price is given in pounds, then the quantity should be in
pounds in order to compare total cost.
Likewise, it may be necessary to convert units of measure for quantities given in the English
system to units of measure for quantities given in the Metric system. For example, suppose the
buyer was asked to order 15 yards of a material, but the prices were given as $47 per meter. The
buyer needs to convert yards to meters to know how much the charge will be. Since 1 yard equals
0.9144 meters then 15 yards equals 13.716 meters and the charge will be 13.716 x $47 or $644.65
assuming the charge will only be for the exact length requested. The following are common
conversions that are helpful to know.
Common Conversions
1 quart = 0.9463 liter 1 gallon = 3.7853 liters 1 inch = 2.54 centimeters 1 yard = 0.9144 meters
Using simple and compound interest.
Buyers should understand the principles of simple and compound interest.
Calculating the value of payment discounts.
There are various types of discounts offered by suppliers. Some are based on the quantity
purchased for a single item or for the amount purchased over an extended period of time. Others
are based on the buyer's type of business. For example, schools and colleges may receive a special
discount.
Most discounts simply specify a percentage that may be deducted from the price. For example, a
supplier may indicate that the buyer may receive a 15% discount. If the published or stated list
price is $50, then the actual price paid will be $42.50. This is calculated by multiplying 0.85
times $50 (remember to convert decimals to percentages you multiply by 100, therefore to
convert percentages to decimals you divide by 100). The answer can be obtained by multiplying
the list price by 0.15 and subtracting the result from $50 or by first subtracting 0.15 from 1.0 and
multiplying the result by $50.
Another type of discount is that for paying early and is negotiated as the payment terms. For
example, 1% 10, net 30 means that a discount of 1% may be taken on the total value of the order
if paid within ten days. It is calculated the same as above except it is taken on the total order
rather than on one item.
Another type of discount is called a chain discount and is given as a series of discounts such as 10,
5, and 5.
Determining the present value.
If the price is the same, it is more costly to pay now rather than later. That is because money has a
time value. Interest is paid for the use of money or interest is lost if money must be spent now
rather than later. Here is the formula for calculating the present value.

P = S/(1 + r)
where P = present value
S = future value
r = interest rate
n = periods
Most buyers use ―Present Value Tables‖ and Financial Calculators to perform present value
computations.

Converting foreign currencies.
Nations use different currency that must be converted to another nation's currency when business
transactions are made between two countries. The conversion factors are different from country to
country and at different times. Buyers must take this into consideration when making an
international purchase and decide on which currency will be used for pricing and payment. There
is a risk in paying more or an opportunity to pay less in one currency rather than the other if the
rate of change is different when delivery is made and payment is due. The risk can be offset by
hedging practices such as purchasing the currency needed for the order at the time the order is
placed.
Measuring domestic and international cost increases.
If the purchase agreement is made in U.S. dollars and the dollar becomes less valuable in relation
to another currency, then more dollars are required to pay for material than would have been
required when the order was placed. Thus the buyer experiences a cost increase, but the foreign
supplier does not receive any more funds or any additional profit.
Negotiating
Who negotiates and types of negotiations.
Everybody negotiates. The baby cries for food or attention, teenagers offer to cut the grass for a
bigger allowance, husband and wife bargain for where to go on vacation. Successful business
people must be good at negotiating to succeed. Full time buyers spend most of their time
negotiating.
What is negotiable.
Everything is negotiable regardless of what is claimed. However, it takes skill to learn what the
other party wants and is willing to give up to obtain their objective.
Types of negotiations.
Buyers conduct quick everyday negotiations by simply asking for a better price or quicker
delivery. More formal negotiations are conducted for major purchases and long-term agreements.
Steps in the formal negotiation process.
Preparation for negotiations improve the chances for obtaining a better deal. The best results can
be obtained by using the following steps.
1. Gather complete information. Learn who the competition is. Learn what the competition has
to offer. Learn what the economic and financial situations are for the industry and for the
supplier. Learn as much as possible about all the individuals taking part in the negotiation.
Learn as much as possible about the product to be purchased. Determine the supplier's most
important needs.

2. Plan the negotiations. Set objectives. Know what you want to accomplish and the ideal
agreement. Decide on what is most important. Decide on the minimum acceptable agreement.
Prepare various offers and counteroffers. Plan the time and site for the negotiation. Plan who
will attend the negotiating session. Plan the strategy and tactics.
3. Evaluate the merits of the supplier's offer. Calculate the costs. Decide on what elements are
acceptable and those that are undesirable or completely unacceptable.
4. Communicate your offer.
5. Answer objections properly.
6. Evaluate counteroffers and offer alternatives repeatedly until agreement is reached or until
further negotiations are deemed impossible.
When you should negotiate.
Negotiations are a continual process. Formal negotiations should be planned at convenient times
for the buyer as well as the seller. Many purchasing professionals limit major negotiations for a
single item or single supplier to one or two times per year.
Why negotiations fail.
These are the usual reasons why negotiations fail.

Inadequate planning Ignoring the give/get principle
Intimidating behavior Impatience
Loss of temper Not listening
Arguing Ignoring conflict
Not communicating
Using the learning curve.
The learning curve plots average labor cost for the number of units produced and slopes
downward. This is explained by the increases in efficiency gained from experience. The use of
the curve helps buyers negotiate with suppliers and to offset arguments for increased prices
resulting from increased costs. As more is produced of new products the labor costs go down.
Purchasing Management
Purchasing has been and probably continues to be an underrated business function. Its importance
can be grasped by realizing that savings from any reductions in costs go directly to the bottom
line. Compare this with the profit produced by increased sales that only increases profits after
deducting the cost of goods sold and the sales expense.
Policies and procedures.
Written policy and procedures help a purchasing department function better. They provide
guidelines to establish uniformity and consistency to the purchasing operation and are easy to
refer to when needed. Written policies and procedures help clarify thinking and lead to a more
efficient operation. They make training of new employees easier. They document rules and
regulations to make enforcement easier. Written manuals provide a way of comparing the stated

policies and procedures with actual practices. Operations should be required to follow the written
manuals or the manuals should be revised to correspond to better methods. Purchasing policy and
procedure manuals are required for company certification.

Advantages and disadvantages of single sourcing.
Sometimes a buyer is forced to use only one supplier for an item. This is the case where an item
is patented or where it would be cost prohibitive to pay for more than one set of tooling. When
there is a choice, there are at least seven advantages of using one supplier for the same item.
Advantages of using a single supplier.
Duplication of effort is eliminated.

Economies of scale are provided.
Negotiating power is improved because of a larger quantity.
Duplicate inventories are eliminated (in process, in transit, or in storage).
The opportunity for consistent quality is improved.
Some of the disadvantages of using a single source are as follows.
Supply protection may be affected by a labor strike or a fire at the supplier's facilities.
The supplier may file for bankruptcy.
Short term negotiating power is reduced because of no competition.
Advantages of using more than one supplier for the same item.
The risk of total supplier failure is reduced.

Competition is enhanced.
There is protection from a strike at one supplier.
Negotiations are easier because of competition and comparative information.
Risk of stock-outs is reduced.
Value analysis - what it is and how to use it.
As practiced in U.S. firms for many years, value analysis techniques were most widely used in
programs designed to engineer unnecessary costs out of existing products. Finally, the more
progressive firms began to follow the Navy‘s lead by establishing what they too called "value
engineering" programs-programs that applied the value analysis concept during the early stages of
the new product design process. And, clearly, this is tile first point at which, should be applied.
This is where the greatest benefits are produced for both the firm and its customers.
What is the mix of value analysis and value engineering applications in American industry today?
No one really knows. But the number of both programs has grown markedly in the last decade,
with value engineering programs setting the pace.
The VE concept finds its most unique use in two kinds of companies—those that produce a
limited number of units of a very expensive product and those that mass-produce products
requiring expensive tooling. In these types of companies, value analysis of all item already in
production is often impractical because it is then too late to incorporate changes in the product
economically. In manufacturing certain electronic instruments used in defense systems, for
example, the production run is often so short that it precludes the effective use of value analysis

after production has been initiated. In fact, the Federal Acquisition Regulations now stipulate that
most major defense procurement contracts must be subjected to value engineering studies prior to
initial production.
A somewhat different situation that produces similar operating results is found in firms mass-
producing automobiles. For example, in manufacturing the body panel for a car, once the design
is fixed and the dies are purchased, it is normally too costly to change them, even though value
analysis studies might subsequently disclose design inefficiencies.
Value engineering utilizes all the techniques of value analysis. In practice, it involves very close
liaison work between the purchasing and supply, production, and design engineering departments.
This liaison is most frequently accomplished through the use of product design teams or various
procurement and production coordinators, who spend considerable time in the engineering
department studying and analyzing engineering drawings as they are initially produced. Once
coordinators locate problem areas, value analysis techniques are employed to alleviate them.
VA/VE Tools
Although different companies stress different variations of the fundamental idea, two general
conceptual tools are basic to tile operation of a VA/VE program:
1 Design analysis of the required product, part, or material
2 Cost analysis of the required product, part, or material
Design Analysis
Design analysis entails a methodical step-by-step study of all phases of the design of a given item
in relation to the function it performs. The philosophy underlying this approach is not concerned
with appraisal of any given part per sc. Rather, the appraisal focuses on the function which the
part, or the larger assembly containing the part, performs. This approach is designed to lead the
analyst away from a traditional perspective which views a part as having certain accepted
characteristics and configurations. Instead, it encourages the analyst to adopt a broader point of
view and to consider whether the part performs the required function both as effectively and as
efficiently as possible. Both quality and cost are objects of the analysis.
One technique many firms use in analyzing component parts of a subassembly is to dismantle, or
"explode," the unit and then mount each part adjacent to its mating part on a pegboard or a table.
The idea is to demonstrate visually the functional relationships of the various parts. Each
component can thus be studied as it relates to the performance of the complete unit, rather than
as an isolated element. Analysis of each component in this fashion attempts to answer four
specific questions:
I Can any part be eliminated without impairing the operation of the complete unit?
2 Can the design of the part be simplified to reduce its basic cost?
3 Can the design of the part be changed to permit the use of simplified or less costly production
methods?
4 Can less expensive but equally satisfactory materials be used in the part?

When viewed in this manner--from the standpoint of composite operation and cost--possibilities
for making component design simplifications frequently are more apparent than is possible under
the original design conditions. This in no way reflects unfavorably on the work done initially by
the design engineer.
The discovery of such potential improvements is simply the product of an analysis will( a
substantially broader orientation than that possessed by the original designer. An organized
VA/VE study usually utilizes a number of individuals with different types of backgrounds,
experience, and skill impossible to combine in the person of a single designer. Resulting design
changes often permit :he substitution of standardized production operations for more expensive
operations requiring special setup work. In some cases, considering the volume of parts to be
produced, an entirely different material or production process turns out to be more efficient than
tile one originally specified.
The specific manner in which a value analyst approaches the problem of design analysis is a
highly creative matter which differs from one analysis another. Each possesses unique analytical
abilities and develops unique terns of thought. Some companies, however require analysts to
follow one or more general approaches which are designed to stimulate and organize their efforts.
T]lose commonly used are (1) the value analysis checklist, (2) the functional cost approach, (3)
the use of brainstorming, and (4) the use of Suppliers.
The Value Analysis Checklist
Most companies develop some type checklist to systematize a value analyst's activity. Literally
hundreds of questions and key ideas appear on these lists.4 Some of them are highly specialized
for particular types of products. Illustrative of the more general questions the following checklist.
First, determine the function of the item, then determine:
I Can the item be eliminated?
2 If the item is not standard, can a standard item be used?
3 If it is a standard item, does it completely, fit the application, or is it a misfit?
4 Does the item have greater capacity than required?
5 Can the weight be reduced?
6 Is there a similar item in inventory, that could be substituted?
7 Are closer tolerances specified than are necessary?
8 Is unnecessary machining performed on the item?
9 Are unnecessarily fine finishes specified?
10 Is "commercial quality" specified? (Commercial quality is usually most economical .)
11 Can you make the item less expensively in your plant? If you are making it now can you buy
it for less?
12 Is the item properly classified for shipping purposes to obtain lowest transportation rates?
13 Can cost of packaging be reduced?
14 Are suppliers being asked for suggestions to reduce cost?
In using this or similar checklists, an analyst evaluates the component under investigation with
respect to each item on the checklist. When a question is found to which the answer is not entirely
satisfactory, this becomes a starting point for more detailed investigation. The checklist focuses

the analyst's attention on those factors which past experience has proved to be potentially fruitful
cost reduction areas.

Quality
Total quality involves every aspect of the business. It differs from traditional quality requirements
that only were concerned about the delivered product. Shipments delivered too early or past the
scheduled date indicate unacceptable quality. Slow response to phone calls or errors on invoices
are other signs of less than satisfactory quality. Professional buyers address the quality issue at the
start of discussions with a new supplier.
The buyer's definition of quality.
The proper quality level is that specified in the agreement or with the order. If the specifications
are vague or incomplete, the supplier is not likely to produce a desired product. Yet, the supplier
cannot be justifiably blamed.
How quality is measured.
Quality checks by inspectors from the buying organization may be made during the
manufacturing process at the supplier's facilities or upon receipt of the material. In either case
inspections should compare the product with the specifications given in the agreement. Wherever
possible, goals should include objective measurements rather than subjective opinion.
Total Quality Management
As defined by ISO:
"TQM is a management approach of an organization, centered on quality, based on the
participation of all its members and aiming at long-term success through customer satisfaction,
and benefits to all members of the organization and to society."
In Japanese, TQM comprises four process steps, namely:
1. Kaizen – Focuses on Continuous Process Improvement, to make processes visible,
repeatable and measureable.
2. Atarimae Hinshitsu – Focuses on intangible effects on processes and ways to optimize and
reduce their effects.
3. Kansei – Examining the way the user applies the product leads to improvement in the
product itself.
4. Miryokuteki Hinshitsu – Broadens management concern beyond the immediate product.
TQM requires that the company maintain this quality standard in all aspects of its business. This
requires ensuring that things are done right the first time and that defects and waste are eliminated
from operations.

Origins
Although W. Edwards Deming is largely credited with igniting the quality revolution in Japan
starting in 1946 and trying to bring it to the United States in the 1980s, Armand V. Feigenbaum
was developing a similar set of principles at General Electric in the United States at around the
same time. "Total Quality Control" was the key concept of Feigenbaum's 1951 book, Quality
Control: Principles, Practice, and Administration, a book that was subsequently released in 1961
under the title, Total Quality Control (ISBN 0-07-020353-9). Joseph Juran, Philip B. Crosby, and
Kaoru Ishikawa also contributed to the body of knowledge now known as TQM.
The American Society for Quality says that the term Total Quality Management was first used by
the U.S. Naval Air Systems Command "to describe its Japanese-style management approach to
quality improvement."[1] This is consistent with the story that the United States Department of
the Navy Personnel Research and Development Center began researching the use of statistical
process control (SPC); the work of Juran, Crosby, and Ishikawa; and the philosophy of Deming to
make performance improvements in 1984. This approach was first tested at the North Island
Naval Aviation Depot.
In his paper, "The Making of TQM: History and Margins of the High-Story" from 1994, Xu
claims that "Total Quality Control" is translated incorrectly from Japanese since there is no
difference between the words "control" and "management" in Japanese. William Golimski refers
to Koji Kobayashi, former CEO of NEC, being the first to use TQM, which he did during a
speech when he got the Deming prize in 1974.
TQM in manufacturing
Quality assurance through statistical methods is a key component in a manufacturing organization,
where TQM generally starts by sampling a random selection of the product. The sample can then
be tested for things that matter most to the end users. The causes of any failures are isolated,
secondary measures of the production process are designed, and then the causes of the failure are
corrected. The statistical distributions of important measurements are tracked. When parts'
measures drift into a defined "error band", the process is fixed. The error band is usually a tighter
distribution than the "failure band", so that the production process is fixed before failing parts can
be produced.
It is important to record not just the measurement ranges, but what failures caused them to be
chosen. In that way, cheaper fixes can be substituted later (say, when the product is redesigned)
with no loss of quality. After TQM has been in use, it's very common for parts to be redesigned
so that critical measurements either cease to exist, or become much wider.
It took people a while to develop tests to find emergent problems. One popular test is a "life test"
in which the sample product is operated until a part fails. Another popular test is called "shake
and bake", in which the product is mounted on a vibrator in an environmental oven, and operated
at progressively more extreme vibration and temperatures until something fails. The failure is
then isolated and engineers design an improvement.
A commonly-discovered failure is for the product to disintegrate. If fasteners fail, the
improvements might be to use measured-tension nutdrivers to ensure that screws don't come off,
or improved adhesives to ensure that parts remain glued.

If a gearbox wears out first, a typical engineering design improvement might be to substitute a
brushless stepper motor for a DC motor with a gearbox. The improvement is that a stepper motor
has no brushes or gears to wear out, so it lasts ten or more times as long. The stepper motor is
more expensive than a DC motor, but cheaper than a DC motor combined with a gearbox. The
electronics are radically different, but equally expensive. One disadvantage might be that a
stepper motor can hum or whine, and usually needs noise-isolating mounts.
Often, a "TQMed" product is cheaper to produce because of efficiency/performance
improvements and because there's no need to repair dead-on-arrival products, which represents an
immensely more desirable product.
TQM, just another management fad?

Abrahamson (1996) argued that fashionable management discourse such as Quality Circles tends
to follow a lifecycle in the form of a bell curve. Ponzi and Koenig (2002) showed that the same
can be said about TQM, which peaked between 1992 and 1996, while rapidly losing popularity in
terms of citations after these years. Dubois (2002) argued that the use of the term TQM in
management discourse created a positive utility regardless of what managers meant by it (which
showed a large variation), while in the late 1990s the usage of the term TQM in implementation
of reforms lost the positive utility attached to the mere fact of using the term and sometimes
associations with TQM became even negative. Nevertheless, management concepts such as TQM
leave their traces, as their core ideas can be very valuable. For example, Dubois (2002) showed
that the core ideas behind the two management fads Reengineering and TQM, without explicit
usage of their names, can even work in a synergistic way.

PART V. PRACTICE CISCM EXAM
Below are “sample questions” from the Body of Knowledge. They in no way represent all
the Body of Knowledge and the questions themselves will not be found on the CISCM
Examination. The content of the questions may, however, be tested.
1. In which type of production environment do managers face the challenges of capital decisions,
technological advances, scheduling service delivery and managing demand to avoid peaks and to
promote off-peaks?
a. low labor intensity
b. high labor intensity
c. low interaction/customization
d. high interaction/customization
2. Under which environmental standard must companies pledge their belief that corporations
have a responsibility for the environment and conduct their business as responsible stewards of
the environment by operating in a manner that protects the Earth?
a. ISO 9000
b. ISO 14000
c. CERES Principles
d. self-certification
3. Which of the following activities should not be a candidate for outsourcing?

a. Activities that have a high degree of variance.
b. Activities that take place infrequently.
c. Activities that require customer specific knowledge.
d. Activities that are low in strategic importance.
4. A car repair shop has four main processes: customer check-in, diagnosis/inspection, repair and
checkout. The check-in process takes 20 minutes; diagnosis and inspection takes 40 minutes;
repair takes 1 hour and checkout takes 10 minutes. Where is the bottleneck in the car repair shop?
a. check-in
b. diagnosis/inspection
c. repair
d. check-out
5. Which of the following statements is incorrect?

a. In a TQM system, the primary rule is to recognize your core competencies.
b. In a TQM system, drivers are typically defined internally.
c. In an ROQ system, customers set the parameters for evaluation.
d. In an ROQ system, marketing selects the quality improvements that lead to the greatest return
on investment.

6. Which of the following is not a challenge of using regression for site selection?
a. Users may not trust the "black box" approach.
b. Regression-based scores do not have intrinsic meaning.
c. Regression scores do not have the accuracy of budget numbers.
d. Firms must have historical data in order to run regression.
7. Contract types:
a. have little relationship to the use of price and/or cost analysis in a specific purchase.
b. reflect the degree of risk the Purchasing Organization desires to assume for performance.
c. are limited to firm-fixed-price and fixed-price-incentive in contracts arrived at through sealed
or competitive bidding.
d. Are determined by the supplier as part of the bid/proposal submittal process.
8. Fixed-price contracts have in common an agreement by the supplier to deliver a product or

perform a service in accordance with the terms and conditions of the contract. Under this family
of contracts:
a. there is an agreement by the Purchasing Organization to pay a price equal to the firm
price specified in the contract or, if the contract includes a tentative price subject to later
adjustment, at no more than a specified ceiling.
b. the parties agree to an estimate of total costs and the Purchasing Organization is not obligated
to reimburse the supplier for costs incurred in excess of that estimated amount.
c. the supplier agrees to use its best efforts to complete contract requirements within the estimate,
to notify the Purchasing Organization should there be reason to think that this will not happen,
and at that time to give the Purchasing Organization a revised estimate of the cost for performing
the contract.
d. the supplier is not obligated to continue performance or otherwise incur reimbursable
expenses in excess of the established estimate unless and until notified by the Purchasing
Organization that the contract funding and the estimate have been increased.
9. The following contract type typically imposes the greatest cost risk and administrative and
audit burdens on the Purchasing Organization:
a. Fixed-price-incentive-fee (FPIF)
b. Firm-fixed-price (FFP)
c. Cost-plus-fixed-fee (CPFF)
d. Fixed-price-with economic price adjustment (FP/EPA)
10. The analytical method that is appropriate for all types of procurement situations and contract
types is called:
a. Cost Analysis
b. Value Analysis
c. Parametric Analysis
d. Price Analysis

11. The two components of cost analysis are:
a. Price analysis and profit analysis
b. Accounting (rate) analysis and engineering (quantitative) analysis
c. Direct and Indirect analysis
d. Estimating and cost/price analysis review
Questions 12 and 13 are based upon the information shown below. Listed below are several
methods of price analysis.
(1)Comparison with other prices quoted/bid/proposed
(2)Comparison with prices established by the market (market prices)
(3)Comparison with catalog prices
(4)Comparison with previous prices paid or quotations received
(5)Comparison with in-house estimates
(6)Comparison with prices determined by parametric analysis or rough yardsticks
(7) Comparison with Producer Price Indices (or other published indices)
(8)Comparison with prices determined by value or visual analysis
12. Which of the above methods would be considered necessary whenever the purchases needs
to adjust previous prices paid for inflation/deflation?
a. (5) Comparison with in-house estimates
b. (6) Comparison with prices determined by parametric analysis or rough yardsticks
c. (7) Comparison with Producer Price Indices (or other published indices)
d. (8) Comparison with prices determined by value or visual analysis
13 Which of the above methods would be considered the strongest method of price analysis:
a. (1) Comparison with other prices quoted/bid/proposed
b. (2) Comparison with prices established by the market (market prices)
c. (3) Comparison with catalog prices
d. (4) Comparison with previous prices paid or quotations received
Problems 14 thru 15 are based upon the below information. There are several methods of
procurement available to the professional purchaser. These methods include the following:
(1) Competitive bidding
(2) Negotiation
(3) Two Step Bidding
(4) Systems Contracting
14. Which of the above methods would be appropriate whenever the purchaser wishes to award a
contract to the bidder providing the lowest bid (assuming the bid is responsive and the bidder is
responsible)?
a. (1) Competitive Bidding
b. (2) Negotiation
c. (3) Two Step Bidding
d. (4) Systems Contracting

15. Which of the above methods would be appropriate whenever the purchaser wishes to take
technical proposals, evaluate them, and then solicit bids from those submitting acceptable
technical proposals?
a. (1) Competitive Bidding
b. (2) Negotiation
c. (3) Two Step Bidding
d (4) Systems Contracting

PART VI INTERNATIONAL SUPPLY CHAIN REFERENCE LIST CONTAINING THE
BODY OF KNOWLEDGE
Commercial Contracting: Otherwise Known as Purchasing

LeRoy H. Graw
Customer Relationship Management Strategic Imperative in the World of e--‐Business

Stanley A. Brown
Designing and Managing the Supply Chain Concepts, Strategies, and Case Studies
David Simchi--‐Levi, Philip Kaminsky, and Edith Simchi--‐Levi
Distribution: Planning and Control Managing in the Era of Supply Chain Management
David Frederick Ross, CFPIM
Introduction to e--‐Supply Chain Management Engaging Technology to Build Market Winning
Business Partnerships
David F. Ross
Introduction to Materials Management, Seventh Edition

J.R. Tony Arnold, CFPIM, CIRM, and Stephen N. Chapman, CFPIM and Lloyd M Clive, P.E.,
CFPIM
Juran's Quality Planning and Analysis for Enterprise Quality (Fifth Edition)
Frank M. Gryna, Richard C.H. Chua, and Joseph A. Defeo
Lean Production Simplified: A Plain Language Guide to the World's Most Powerful Production
System (Second Edition)
Pascal Dennis
Manufacturing Planning and Control Systems for Supply Chain Management (Sixth Edition)
Thomas E. Vollmann, CFPIM, William L. Berry, D. Clay Whybark, and F. Robert Jacobs
Project Management: A Systems Approach to Planning Scheduling and Controlling, (10th

Edition)
Harold Kerzner
Supply Chain Logistics Management

Donald Bowersox, David Closs, M. Bixby Cooper
The Lean Toolbox (Fourth Edition)

John Bicheno, Matthias Holweg
All the above (except Commercial Contracting) are available from Amazon.com. Commercial
Contracting is available at www.ipscmi.org.

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CISCP-CISCM STUDY GUIDE

©International Purchasing and Supply Chain Management Institute, 2012 1

©International Purchasing and Supply Chain Management Institute, 2012 2

There are three phases to the flow of materials:

Raw materials are processed by manufacturing.

Conflicts in Traditional Systems

Other ―Sub optimizing‖ can take place in the overall system.

There are four main ways to maximize profit:

1. Provide best customer service.

2. Provide lowest production costs.

3. Provide lowest inventory investment.

4. Provide lowest distribution costs.

Objectives and Departments are often in conflict.

Marketing, production, and finance have conflicting objectives.

©International Purchasing and Supply Chain Management Institute, 2012 3

 Interrupt production runs so a noninventoried item can be supplied quickly.

 Reducing inventory so inventory investment is at a minimum.

 Reducing the number of plants and warehouses

 Producing in large quantities using long production runs

 Producing only to customer order.

 Maintaining high inventories of raw materials so production is not disrupted by shortages.

Conflict Resolution Strategy

To do so requires a type of integrated materials or logistics organization responsible for supply,

©International Purchasing and Supply Chain Management Institute, 2012 4

The name usually given to this function is materials management.

Reducing material flow costs contributes directly to profit.

Components of Supply Chain Management

Manufacturing Planning and Control

 Production planning, including forecasting and master planning.

©International Purchasing and Supply Chain Management Institute, 2012 5

Inputs to the Manufacturing Planning and Control System

 Engineering drawings and specifications.

Physical Supply and Distribution

©International Purchasing and Supply Chain Management Institute, 2012 6

The overall concern is the balance between priority and capacity.

Capacity is the ability of the system to produce or deliver goods.

Manufacturing Systems (Three Types)

1. Line flow manufacturing

2. Intermittent (batch) manufacturing

Line Flow Manufacturing

Line flow systems only produce a limited range of similar products.

©International Purchasing and Supply Chain Management Institute, 2012 7

 They are designed specifically for the tasks required.

The Flow and the coordination of variety must be planned.

The manufacturing planning and control system is called flow control.

Work stations must be capable of processing many different parts.

Intermittent operations are flexible.

©International Purchasing and Supply Chain Management Institute, 2012 8

©International Purchasing and Supply Chain Management Institute, 2012 9

Sometime called Fixed Position Manufacturing.

Large aircraft are made this way

Manufacturing creates wealth by adding value to goods.

©International Purchasing and Supply Chain Management Institute, 2012 10

A planning and control system must answer four questions:

1. What are we going to make?

2. What does it take to make it?

4. What do we have to get?

Questions of priority and capacity

©International Purchasing and Supply Chain Management Institute, 2012 11

Levels Differ With Respect To:

 Purpose of the plan

Three Appropriate Questions at Each Level

2. What is the available capacity?